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DON'T TRUST THE REGULATORS.
It's one of the unfortunate wrinkles of the regulatory process that it tends to occur at the moment when it's least necessary. For instance: We really could have used some good financial system regulation eight years ago. But we're going to get it now. And it will protect against all the things that no one will do for a long while, and will likely not protect against the many things that will cause the next crisis.
James Kwak suggests we imagine what would have happened if Alan Greenspan had been a more empowered regulator in 2005. That, of course, is when he said “we don’t perceive that there is a national bubble”, just “a little froth.” In March 2007, Bernanke said “the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.” Given regulatory authority over Citibank's leverage, how likely do you think it is that Greenspan would have used that authority?
It's nice, in other words, to have a systemic risk regulator, as Geithner suggested in his testimony. But it's not an obvious solution. The tendency is for the regulator to be least effective when he's most necessary. Think too about how much money, and thus political power, a "too big to fail" company possesses. "It's best," says Kwak, "to minimize the chances of systemic risk getting big in the first place." Better than empowering regulators to examine companies that are "too big to fail" would be keeping the companies from becoming "too big to fail" in the first place.
"Size can definitely go away," argues Kwak, "simply by setting a cap on the volume of assets any institution is allowed to hold (and doing something about off-balance sheet entities). And if a highly interconnected, highly complex but small financial institution fails, the system as a whole would be fine." I imagine there are a lot of options for regulating size. And I imagine there would be a lot of arguments about how to determine the cap. But this is the right way to think about the regulatory changes. It's a policy that prevents our reliance on omniscient regulators rather than a policy that depends on their existence and independence. In that way, it's actually a relatively conservative -- or at least public choice-oriented -- way of looking at the problem, though I doubt it'll gain much bipartisan support.
COMMENTS (13)
A very large part of the problem is that regulators have mixed (or potentially contradictory) objectives.
Take the Fed. It has goals to keep the stability of the financial system (and its money) relatively stable. It also has a goal (hardly ever acted upon) of keeping employment sustained.
Any risk management activities must take place in this bigger setting. So, risk gets minimized because it runs counter to the bigger goals.
Some wise and foresighted companies have set up separate and powerful executives and organizations to just monitor risk. They have no other objectives.
Giving the Fed or other existing regulators a new objective for managing risk will probably not lead to aggressive risk minimization.
Hence, the need for a Federal Private Financial Risk Oversight organization. It should have the power to direct FDIC or the FED to open investigations, or to open those investigations and issue cease and desist orders (perhaps limited in time until other regulatory activities can react).
Somebody has to have the Risk Control job - or the entire industry needs to be restructured such that no institution or small group of institutions following each other's direction is a danger. This later is improbable, so Risk Control it is.
This Risk Control Supervisory Agency should report outside Treasury (so Lloyd Summer/Robert Rubin can squish them for being a bother). Perhaps OMB?
Risk Control Officers in corporations came to be as follow-ons to the rise of hedging, derivatives and other financial slight-of-hands that could get a company in deep doodoo (like Enron, or LTCM) with no way out of trouble because the pit was so deep already.
Our entire financial system is now so complex that the normal 'regulatory' function is inherently responsive rather than pro-active. Tricks can be made up faster than they can be discovered.
Risk Management should let its freak flag fly in the highest places in the government. Let them be the mean sons-of-bitches that finacial folks hate but taxpayers can trust. Cease and desist, baby. Cease and desist.
Posted by: JimPortlandOR | March 27, 2009 2:39 PM
I don't know about this post, it sounds like a repackaged "don't trust government" meme that is so popular with right wing nutjobs. Hey if you don't trust Government, then shut-up and move to Sierra Leone.
I trust / don't trust based on their record.
Geithner's record is simply awful, as is Summers.
FDIC's record is nearly flawless.
Posted by: S Brennan | March 27, 2009 3:07 PM
Ezra-the regulations did exist. They were removed. Deregulation lead to the S&L Crisis (which was also a smaller banking issue). Deregulation has now lead to this banking crisis. No one is saying move back to government set interest rates but to pretend that this is new is wrong.
Posted by: Rob | March 27, 2009 4:10 PM
I'm curious if Ezra knows what that picture is of.
Posted by: Chemjobber | March 27, 2009 5:35 PM
Any new or improved regulations are meaningless unless they get control over unregulated derivatives. Credit swaps alone equal $55 Trillion, which is about the same as the entire world's GDP. The current total value on derivatives is about $600 Trillion.
For details, listen to the interview of Frank Partnoy, or read the new Afterward to the book he wrote in 1997 and has just been re-released. Both are at:
http://www.npr.org/templates/story/story.php?storyId=102325715
Posted by: Mr.E. | March 27, 2009 5:55 PM
Oh I think Ezra knows. Very punny.
Posted by: labrat | March 27, 2009 6:15 PM
Think too about how much money, and thus political power, a "too big to fail" company possesses.
If too big to fail was the big issue here what was the single too big to fail company that brought us down. Are you saying that it was only City Group, Lehman Brothers and AIG that brought the system down?
Say 8 years ago City Group, Lehman Brothers and AIG had each been split into 4 companies each, I think that we would have just had a bunch of companies failing now and be in just as bad shape. After all other institutions have failed not just those 3 and some that have not failed may have if not for Bailout money. If we had split GM and Chrysler would the resulting companies be OK right now, I think not.
Posted by: Floccina | March 27, 2009 6:37 PM
I still believe that focusing on size alone is the wrong target. It's just as bad if 10,000 smaller institutions fail rather than just 100 big ones. If we're trying to deal with systemic risk, we need to make sure that the institutions, no matter their size, are not all taking the kind of risks which expose them to systemic risk.
There seems to be an illusion that reducing the size of the players can be a substitute for smart and effective regulation. It helps, because it increases the number of players you need to be subject to a systemic risk, but it doesn't eliminate the possibility.
Posted by: Patrick Earnest | March 27, 2009 6:43 PM
FDIC handles bank failures on a daily basis, having "10,000" simultaneous bank failure is silly conjecture. we're talking about four major banks her.
"It's just as bad if 10,000 smaller institutions fail rather than just 100 big ones."
Posted by: S Brennan | March 27, 2009 8:47 PM
From 1982 to 1992, over 2000 financial institutions failed. This is not silly conjecture. A bunch of small but highly leveraged S&Ls was responsible for the S&L crisis, eventually coming in with a price tag of $160 billion. If we break the big banks down, but fail to regulate them properly, we'll still have the same kind of dangers that brought us to the current mess.
Smaller is better - but it's only part of the solution, not the solution to the problem of systemic risk.
Posted by: Patrick Earnest | March 27, 2009 9:36 PM
This GSE report:
http://www.gsereport.com/2000/April8-May5.pdf
shows there was already trouble and major concern with Fannie and Freddie in early 2000. Worth a look.
Posted by: JAB | March 28, 2009 2:46 PM
Nice theory but won't happen for the simple reason that even if courts support such an unconstitutional power grab, the companies in question will simply cross link their assests with other companies' assets so that the "too big to fail" becomes "groups too big to fail". Until responsible individuals are sent to prison, NOTHING will change.
And BTW it would be a good idea to send a few Congressmen and Senators (Frank, Dodd, Pelosi, Schumer, Durbin, Reed and Grassley) to the can too.
Posted by: tim stevens | March 28, 2009 4:52 PM
It's interesting to see you & Yglesias (two of the progressives I read regularly) thinking seriously about the fallibility of regulators. But I don't know why you both think that size regulations are somehow exempt from this problem. As the off-balance-sheet transactions during this bubble demonstrated, "size" can be gamed just as surely as any other kind of regulation.
In this regard, it's interesting to note that Glass-Steagall's lines-of-business rules (which were pretty similar to a size rule) had been significantly undermined through the waiver process before they were formally repealed. That suggests that size rules can be undermined by regulatory complacency, just like other kinds of rules.
Posted by: matth | March 29, 2009 12:32 AM