To keep the public blaming Wall Street for their current miseries, the Obama administration has announced that it is reviewing banking regulation, with a view to appointing a single regulator for the financial services industry. Skeptical as I am of the value of regulation, I am only too well aware that different regulatory systems make a huge difference in practice. I thus thought it worthwhile to review the possibilities.
In order to examine the effectiveness of regulation, you need to look at the motivations of regulators. The Food and Drug Administration, for example, has bolstered its legitimacy for half a century by having moved so slowly in 1957-60 that it never got round to legalizing thalidomide, which caused birth defects when given to pregnant women. Since its “success” in that case, the FDA has generally been motivated by an extreme risk-aversion. This has delayed by years the introduction of new therapies to the US market, and as side-effects has concentrated drug research and development in slow moving behemoths and given the pharmaceutical industry a “cost-plus” culture that has driven US medical inflation to economy-sapping levels.
In general the incentives on regulators represent a tug-of-war between the regulated industry and the natural bureaucratic concern about the consequences of laxity. In bull markets, regulators are captured by the industry concerned, and so regulation becomes too lax. In bad times, as currently in the banking sector, the adverse consequences of laxity become only too clear and so political pressures cause regulators to pile regulation upon regulation, seeking to shut the door after the horse has bolted.
This can be illustrated by considering two misguided regulatory efforts of the last decade. In April 2004, the SEC, under pressure from the brokerages in a period of easy money and a steep yield curve (which makes leverage more profitable if you borrow short and lend long), agreed to exempt brokerages from the net capital rule which had previously restricted them. This now looks incredibly foolish; it led to the 30 to 1 leverage ratios at the major brokerages going into 2008, which in turn led three of the five to effective bankruptcy within that year. It should have been obvious that without some kind of restriction on leverage, investors with accounts at those brokerages would not be protected unless the taxpayer was called in to fund a bailout. Surprisingly, in the bullish atmosphere of 2004 this wasn’t obvious, even to an SEC led by Bill Donaldson, himself founder of the major brokerage house Donaldson, Lufkin and Jenrette.
In the other direction was the Sarbanes-Oxley legislation, passed in a frenzy in 2002 by a Congress under pressure from its constituents after the dot-com crash and the Enron bankruptcy. This failed to address the major problems of the dot-com era, which were mostly caused by poor shareholder governance and accounting laxity. Instead it imposed legal requirements on even quite small companies that have since proved hugely costly, at close to $5 million annually for small public companies. Section 404, in particular required companies to get their internal control systems audited and has proved a bonanza for the accounting profession and a huge cost for everyone else. Sarbanes-Oxley has caused a high proportion of major foreign public companies to de-list themselves from the New York Stock Exchange, with the unintended consequence of raising an artificial barrier to the globalization of capital markets and effectively barring many large foreign companies to US retail investment.
In an ideal world, financial sector regulation would be unnecessary. Monetary policy would be self-regulating, while banks and investment banks would be constrained by their depositors and securities customers. Since a self-regulating monetary policy (such as the Gold Standard, but not necessarily limited to that possibility) would push up interest rates at moments of speculative excess, such as after 1997, neither financial institutions nor their customers would be able to forget the periods of stringency that followed excess – they would happen too often.
Like most of the classical free-market model, this ideal is of only limited applicability in the real world. When investors and markets in general are not rational, and monetary policy is subject to the political desire to keep the economy forever in expansionary mode, conditions are sufficiently distorted for the free-market unregulated model not to work too well. By regulation, one is always searching for a second-best solution, and recognizing that the solution will itself impose further distortions on the classical system, but this is economics not theology and accommodations must be made.
However consideration of the free market ideal highlights the flaws in some of the proposals. Having the Fed regulate the financial system, for example, is clearly a very bad idea. The Fed has been demonstrating since 1995 that it is prepared to subordinate monetary policy to the political desirability of perpetual expansion. It has even attempted to justify this perpetual expansionism by calling it the “Great Moderation” when moderation is the one feature of a well-functioning market that the Fed’s expansionism most certainly destroys. A Great Moderation that leads oil prices to double to $147 per barrel within a year, then drop by three quarters, then double again from the bottom in only a few months meets no definition of moderation that a linguist would recognize.
As a highly political institution and one with a perverse and dangerous built-in tendency towards expansionism, the Fed is thus the least suitable entity on earth to regulate the US banking system (well OK, maybe Vladimir Putin’s FSB would be worse!). Moreover, it has the power as it has demonstrated over the last two years to print money every time anything goes wrong; hence being like any bureaucracy eager to hide errors it prints money to hide any defects that appear in the banking system, hoping to rectify the banks’ asset problems by means of a burst of inflation.
This of course precisely what it has done in response to the housing crisis, a tendency for which the reckoning has not yet arrived. However the recent sharp rise in the 10-year Treasury bond yield is beginning to hint that the bill will be a gigantic one. If it continues, that rise in interest rates will push the housing market back towards further price declines, even though prices are now close to their long-term equilibrium – which will once again destabilize the banking system because of the destruction of mortgage credit quality such further declines would cause.
Instead of a regulator with the power to print money to cover up its mistakes, and the incentive to do so, I would propose a regulator whose incentives are in the opposite direction. The Federal Deposit Insurance Corporation takes over bad banks when they fail, and charges the banking system fees for its insurance activity. Since it does not want to have to go back to Congress for more money, it thus has an incentive to stamp out risk-seeking behavior in banks and mandate tight leverage and accounting rules to avoid problems occurring. Furthermore, since the FDIC charges fees to banks based on its loss experience, there would be an incentive for a naughty bank’s competitors to “snitch” when its risks got out of line, thus both cutting down underpriced competition and risky activity that might lead to higher FDIC fees in the future.
Of all the regulators in this mess, the FDIC’s Sheila Bair is emerging from it best, with her reputation enhanced and her institution’s powers properly used, without excessive power-grabs at the expense of other regulators or the private sector. Naturally, it appears that the FDIC will need quite a lot more money from Congress for its bank bailout efforts, but that is hardly its fault since it does not currently regulate the banking system.
This recommendation tallies with British experience. Before 1998 the Bank of England, which had responsibility for bailouts (as it demonstrated in 1890 and 1973) was also the regulator. The result was a system which experienced no bank failure for 141 years, between Overend, Gurney in 1866 and Northern Rock in 2007. Moreover, before 1997 the Bank did not have full responsibility for monetary policy; that was shared by the Treasury (and before 1931 was set by the gold market). The Bank of England’s money market duty was limited to its role in crisis management, described in 1873 by Walter Bagehot as “to lend on good security, but at a high rate.” Thus the pre-1998 British regulator of banks (though not of the securities market) had roughly the same incentive structure as the FDIC.
The post-1998 British regulatory system, controlled by the Financial Services Agency, suffered from the twin evils of bureaucracy and regulatory capture. Small institutions were stifled by regulatory costs, in a similar manner to small public companies under Sarbanes-Oxley, while large institutions were allowed to over-leverage themselves and concentrate risk in a way that should have been prevented. However the FSA, which had no responsibility for bailouts but was a child of the 1986 Financial Services Act disaster, which wiped out the British merchant banks, was consumed by the London market’s attempt to overtake New York as the world’s premier financial market. The RBS takeover of ABN-Amro, in particular, was a case of megalomaniac management overpaying at the top of the market, which a regulator properly concerned with the health of the financial markets would have prevented.
An FDIC regulator, responsible for bailouts, would rein in the banks in a number of ways, notably by imposing tight regulation of derivatives, probably banning credit default swaps altogether as generators of risk out of proportion to their benefits. It would thus be highly unpopular with the banking system, and will no doubt be resisted. The banks’ resistance should be overruled. Financial services will be a significantly smaller business in the next 20 years, much better capitalized and much less profitable – all of which means lower rewards for its practitioners. That is a development to be welcomed by the rest of us.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)