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How good can financial regulation become?
Megan McArdle asks and here is her follow-up post. I would suggest the following:
1. Given the existence of a lender of last resort, *everyone* favors capital requirements of some kind, at least if you prefer to close down bankrupt institutions rather than to let them continue borrowing from the Fed and gambling with the money.
2. It makes sense for some of these capital requirements to be upfront and clear ex ante, noting that any attempt in this direction will be imperfectly realized.
3. Most observers overestimate how effective capital requirements will be. Many a crisis has happened right under their nose and that includes Japan and Bear Stearns, among others.
4. As Megan suggests, regulators are not very good at outguessing the market; read Arnold Kling as well.
5. Regulation can discourage leverage at the margin; the social costs of leverage are higher than the private costs, due to contagion effects and the inability of the lender of last resort to precommit to no bailouts. This need not require selective regulatory intervention or regulatory outguessing of the market.
6. A good deal of regulation requires voluntary compliance on the part of the financial institutions rather than foresight or intelligence on the part of bureaucrats. Banks of course don't *have* to follow the rules they are given and sometimes they don't. But for a bank to cross the line of systematic legal disobedience, observable by potential whistle-blowers and the like, is a big step and many of them are not willing to do this. Much of the power of financial regulation derives from this fact rather than from any particular abilities of regulators.
7. We should make capital requirements as symmetric as possible across different kinds of banking activities, at least to the extent systemic risk is present. That said, this still probably won't prevent the next bubble and blow-up. It will limit some of the damage ex post.
8. It would be nice to have greater use of clearinghouses and netting of positions for the unregulated "shadow banking sector."
Posted by Tyler Cowen on June 12, 2008 at 12:48 PM in Economics | Permalink
Comments
the social costs of leverage are higher than the private costs,
This is crucial.
More broadly, firms like investment banks, who profit by taking on financial risks, may impose some of those risks on the economic system as a whole. That is why the argument that incentives are aligned does not hold when firms start pushing the limits. They are gambling, partly, with our money.
McArdle and others are right that it is difficult to design an optimum regulatory scheme. But let's look at the other side of this question. Suppose it's not optimal and interferes somewhat with the efficiency of the credit derivatives market, or some similar activity. Is the social benefit from from all this really so great that a loss of some marginal amount of it would be harmful?
Posted by: Bernard Yomtov at Jun 12, 2008 4:46:47 PM
Do you think the social costs of leverage are negative ALWAYS or just really high leverage? I would think that some amount of leverage is good.
Posted by: jsalvati at Jun 12, 2008 5:23:21 PM
The other aspect that seems to be missing from the discussion is disclosure. Why didn't the holders of CDO's have any real idea of what was included in them, in terms of the breakdown of credit quality, for example? Why are off-balance-sheet investments so opaque? In fact, I'm not sure what the purpose of off-balance-sheet accounting is, other than to confuse investors. If we mandated better reporting for some of this stuff, I think it would enable the market to get less caught up in these kinds of excesses.
Posted by: Greg at Jun 12, 2008 6:08:04 PM
A credible threat to hang bankers who really cock up might also prove helpful.
Posted by: dearieme at Jun 12, 2008 6:15:27 PM
The real issue was that banks, like the buyers, “knew” that US house prices “always go up”.
As soon as this usual truism began to be treated like a law of house price anti-gravity, and then depended upon, everybody wanted to get as much upside as possible—since the prices only went up. No risk, try for maximum gain!
There SHOULD be a 50% windfall / irresponsibility surtax on all bonuses paid to financial folks making 10x annual avg US wages (~$450 000) at companies which have lost money on subprime mortgages.
The new moral hazard is that private fat cats can take big risks and, if OK, get all the profit, but if there’s a bust, the risk is covered by Uncle Sugar. Starting back at the Long Term Capital Management bailout—the individuals should have had surtaxes on their prior year’s bonuses.
Posted by: Tom Grey - Liberty Dad at Jun 12, 2008 8:03:40 PM
I don't see how to equalize capital requirements across different financial sectors.
There has been an enormous under recognition regarding the extent to which stone age legacy regulations have held up compared to anything implemented after the invention of computers. If things had sailed along another few years, all of it would have been gone, (except the FDIC) since it is anything but efficient.
Posted by: ziggurat at Jun 12, 2008 9:22:40 PM
Your reflections on capital regulation are interesting, likewise the reflections in the blogs you cite and the comments you’ve received. But I find it hard to connect the reflections with actual capital regulation, a type of financial regulation.
Financial regulations are akin to building codes, and regulators are like building inspectors. Building codes don’t guarantee that if a skyscraper is built in compliance with them, it won’t fall down. They’re rules that if complied with give reasonable assurance that it won’t fall down for reasons structures in the past have fallen down. Likewise for capital regulations.
Consider for example the Basel capital regulations on market risk. They are rules for measuring market risks and for management and oversight of trading activities based on past experience. As far as I can tell, to evaluate compliance with these rules, a regulator needs to understand and be familiar with trading activities, but doesn’t need the abilities or education of a highly paid quant.
But if I’ve correctly understood you, the bloggers, and the commenters, you all think that good capital regulation should be original, deep, and preferably involve differential equations -- something the Black-Scholes model; and we need regulators who might have worked as quants in a hedge fund, e.g. LTCM. Maybe you’re right. Why not strengthen your case by, e.g., identifying those Basel market risk requirements that only a quant or tenured finance professor at a good school could evaluate?
Posted by: PeterE at Jun 13, 2008 1:30:01 AM
Transparency. Deal with leveraged companies at your own risk. Enforce contracts. Punish managements.
I'm usually pretty objective, but I'm perfectly fine snapping up assets marked down to pay dumb bankers margin calls. I don't mind profiting for my country.
Posted by: Andrew at Jun 13, 2008 3:57:34 AM
These people undermine families and microlending potential by leveraging their profits by fractional reserves. And they get bailed out by holding the rest of us hostage by threats of "contagion" that the Fed has supposedly been trying for going on 100 years to prevent, but it keeps happening. What other problems have we been "failing" to solve for 100 years? Not many.
Any measures based in any portion on sympathy for these people is worthy if ridicule. When do we think about a non-non-falsifiable thesis for this lender of last resort stuff? I'm not even clear how much a lot of credit works to a net benefit to be such a sacred cow. Wealth is built by innovation and capital efficiency. Wherever lending doesn't support this, it's not helpful.
Posted by: Andrew at Jun 13, 2008 4:08:11 AM
What Andrew said.
Fractional-reserve banking looks dead to me.
The Austrians were/are right.
Now tell me.
What good will more regulation do?
Do you have your donkey yet?
Posted by: jomama at Jun 13, 2008 6:41:07 AM
The Fed's ability to lend to undercapitalized institutions is limited by statute.
Posted by: jorod at Jun 13, 2008 11:15:21 AM
As a former high yield bond trader when you over regulate, epspecially in the riskier markets. You run traders out of the markets. It ruins risk-reward ratios.
Posted by: Mike at Jun 13, 2008 1:00:30 PM
"Suppose it's not optimal and interferes somewhat with the efficiency of the credit derivatives market, or some similar activity. Is the social benefit from from all this really so great that a loss of some marginal amount of it would be harmful?"
What are the indirect and direct costs of the credit crisis so far?
The total costs must be far larger than the profits generated during the good times, far far larger.
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