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The realignment of the regulatory powers
Two thoughts: First, the very active role of the Fed in the Bear Stearns crisis must, in the long run, give rise to a fundamental revaluation of the role and powers of the SEC, the entity technically responsible for investment banks. The SEC now appears relatively toothless.
Second, the more commitments made by the Fed, the more we lose the (quasi) independence of our central bank; for a large commitment Treasury sign-off is needed. The realignment of the regulatory universe will eventually emerge as a big story from the current crisis, though it is hardly commanding much attention right now.
Paul Volcker comments.
Posted by Tyler Cowen on March 19, 2008 at 08:27 AM in Law | Permalink
Comments
The Fed's got money and the SEC hasn't. It's not abnormal to have dispersed rulemaking but the Fed ought want some control now that it's on the hook.
Posted by: misplaced trust co. at Mar 19, 2008 9:22:28 AM
Bear Stearns got into trouble by holding a large amount of mortgage-backed securities. This had been very profitable to them and they let it grow and grow, ignoring the wisdom of diversification. Diversification can protect you from large risks that you don't know about -- and don't know you don't know about. (Did they arrogantly think there was nothing they didn't know?)
When the housing bubble popped and the foolish sub-prime lending practices were revealled, Bear was affected more than any other large financial institution other than the housing lenders and bond guarentors themselves.
The Fed strategy to stablize the banking system has largely been to prevent a fire sale of mortgage-backs. They allowed banks to treat them as sounder collateral than they warrent and encouraged institutions to set up SIV funds to hold them until market condtions improve.
Bear, as a brokerage firm, is primarily regulated by the SEC rather than the Fed, but if Bear had gone under its mortgage-backed portfolio would have flooded the market and swept away the Fed's house of cards. So the Fed stepped in.
The moral? You can't draw a line around a set of firms called banks and guarentee their assets without the resulting moral hazard spilling over to other financial institutions.
Posted by: John Kunze at Mar 19, 2008 11:38:33 AM
Apparently the Fed did not contact the SEC about this bailout until after the fact. But there are several issues here. The first is that the Fed effectively created an unregulated shadow banking system in the form of the hedge fund and private equity industry, arguably because Greenspan and the other governors feared that their own banking regulation was stifling the U.S. market. (Greenspan, if you recall, came out publicly against SEC regulation of the hedge fund industry.) It has been apparent since at least LTCM that the unregulated private markets between institutional investors had at least the potential for systemic risk, and over the past several years it also became apparent that these institutional investors had replaced regulated banks in supplying commercial paper and leverage to many of the world's corporations and financial firms. In other words, at the same time that the Fed had figured out ways to protect regulated banks from financial contagion, and forged an international concensus through Basel II to do the same around the world, it opened a gaping back door to financial contagion through this shadow banking sector. And, worse, it fought other agencies (first the CFTC, then the SEC) who actually did try to rein this sector in.
Second, of course, the Fed (and other U.S. banking regulators) took an extremely lax view of consumer protection with regard to predatory lending, mortgage fraud, and lending due diligence. And it refused to crack down on these practices, even in the face of widespread anecdotal information about an increase in fraud and clear housing bubbles in many markets. (Insisting, for example, that the United States has no "national" housing market for there to be a system-wide housing bubble to pose a risk.)
Third, of course, were decisions the SEC and Fed made, in the face of European pressure, to create a "consolidated" regulatory approach to large financial firms. The idea here was that any global firm operating in Europe would need to approach matters such as capital adequacy from an organization-wide perspective, to keep failures in one part (say, the private hedge fund area) from dragging down other areas (retail broker-dealing). The problem with this, of course, is that the SEC has no experience and no real skillset for prudential regulation of this nature. The SEC is more of a cop than a regulator -- it has a disclosure-based regulatory mindset, sets rules and executes violators. It's not much into nursing them back to health, seeing this as undermining its ability to deter those who violate the rules. Worse, under the old system, the firewalls between Bear's different divisions might well have staved off threats to investor confidence, since capital in one area couldn't be used to buttress confidence in another. This would have led to a collapse of parts of Bear much earlier, but might have saved other parts. Instead, we had a complete collapse.
Posted by: M.D. Fatwa at Mar 19, 2008 4:00:11 PM
there is almost no doubt now that there will be increased regulation as a result of this crisis. If we are privitizing the profits and socializing the losses, and we clearly are at this point, then increased regulation will be the outcome.
There is no doubt the self-policing as practiced by the IBs has failed. If the ratings agencies would accurately rate the bond insurers, there would be a string of defaults all through the world of finance. So they are lying to prop up a financial system. Lying in the long run is unsustainable
If as John says "You can't draw a line around a set of firms called banks and guarentee their assets without the resulting moral hazard spilling over to other financial institutions." we either need to deregulate the banks entirely or regulate other ones. Last time the banks were deregulated, the great depression happened, but even before that there was a cycle of boom and bust that was not acceptable to modern people.
Posted by: mickslam at Mar 19, 2008 5:41:27 PM
mickslam, you need to study your economic history more.
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