Why Lawmakers and Experts are Wrong About the Financial Crisis
And why the current planned regulation is almost guaranteed to be dismantled
Although some might argue that the point is moot at this point, it appears that the broader financial analyst/reporter community has suddenly decided to adopt collective amnesia and paint financial regulation as the boogeyman that brought the financial industry to its knees. Of course, this is the same community that happily declared the beginning of a “new era” in investment and stocks during the tech boom (which busted), along with enthusiastically invented reasons why the real estate market could never go down even though it has gone both up and down throughout all of human financial history.
Overall, I suppose it shouldn’t come as that much of a surprise, given that track record and the relative ease that one can blame recent changes in the regulatory framework. Especially given that it comes with a very easily swallowed “us versus them” story of greed, corruption, and all those bad things. However, they’ve been wrong before, and I’m going to relatively confidently say they’re wrong again about the reason for the financial crisis—and why, ultimately, all of this hubbub about regulation, for better or worse, is mostly hot air.
But why does it matter?
But first, why bother with this question at all? After all, the credit markets have already frozen, and lack of liquidity along with massive bank runs/shorting have already driven under some household names, Wachovia, Washington Mutual, and—among the high-rolling investment banks—Bear Stearns and Lehman Brothers.
The problem with just ignoring this now is that the bailout plan and future regulatory framework is being based on the erroneous assumption that it was purely deregulation that, coupled with the ever-popular “Wall-Street greed,” blew up the markets.
Putting aside the fact that economic markets and companies in that market are supposed to be pursuing profit and the most efficient ways of allocating their resources (given that it’s how our economy as a whole functions effectively), it simply isn’t the whole story.
Financial deregulation played a proximate cause to the entire crisis, but is only the final chapter in an industry that was spinning problems for itself because lawmakers had distorted its incentives.
The Regulation that Came Before Deregulation
The public loves easy explanations. Politicians love it even more, because it allows them to feed it to a receptive public who promptly turns into a mob that demands that heads roll—a demand that is far easier to fulfill than actually solving anything.
So what was the beginning of this story of financial disaster?
One can argue that the very beginning was in 1988, in Basel, Switzerland after a series of global financial disasters throughout the entire world. Central bankers convened and by 1992 had created a global framework of risk management for banks (at least in the G10 countries) that threw the first bit of tinder that would one day turn into the conflagration that now engulfs the U.S. financial market (and Europe’s, but they haven’t written it down yet—watch for even more financial turmoil in Europe to come), and is spilling over onto the rest of the world.
It did what seemed so logical at the time. It put risk management policies into place which classified various assets on a bank’s balance sheet and regulated the amount of reserves banks had to hold to make up for it.
Although there were some changes in Basel II, the essential idea was intact. Sarbanes-Oxley put together even more tinder under the financial powder-kegs that the banks and “non-banks” would soon pile up on top of it.
But what’s wrong with risk-management?
Nothing. Except when it’s forced upon an institution and regulated in a competitive market.
The problem with expecting these regulation to really reduce any appreciable risk in the market is that laughable idea that banks and other financial institutions can simply sit back, reduce risk, and not have any negative consequences come about it.
It’s blindingly obvious enough for other types of companies. What happens if one day, an auto manufacturer decides that it is simply going to stop investing as much into new models and cut customer service, for instance? Obviously, it’s going to lose business and eventually either go out of business, or get bought up by another company for cheap. The company that becomes complacent, when there is competition, is simply not going to survive.
The same is true with banks and other financial institutions.
Their input and output, however, is money. If you got paid a lower interest rate on your savings deposit, or got a higher interest rate on your loan, would you do business with that bank? It’s all the same concept.
By imposing reserve requirements, the reserved money is essentially sitting around doing nothing. Thus, the bank would effectively be slacking off. The bank that does this the most either goes out of business, being out-competed, or bought out by a rival. No bank is going to sit around and just take the fact that it has now been severely regulated—not if it wants to survive.
Thus, upon this happening, it was a free-for-all scramble to invest in any many assets that weren’t under regulation, and couldn’t be—because they didn’t exist when the regulation was made. Hence, in large part, complex derivatives, mortgage-backed securities, and other packed financial products, which didn’t have to be put on a balance sheet forcing institutions to have to leave reserves for them.
It’s impossible to regulate everything, in large part because the only way to do so is to forbid everything except a few selected financial products—in essence, doing the same thing as forbidding the technology industry from creating anything new.
Given that it is their job, the highly-paid bankers, most picked out of the cream of America’s college crop every year, will always be able to find some way to work around the inadequate regulation set up by overworked, hourly regulatory employees. Unfortunately, the way they find ways around this regulation might be far riskier than the original investments. Like with this current crisis, and the previous quickly-forgotten by foreshadowing crisis in SIVs (structured investment vehicles). Regulation drove banks away from the safe investments.
Deregulation also brought us to our financial knees, of course. Why? Simple, now that banks are pursuing these incredible risky investments, the SEC and other financial regulatory authorities suddenly removed many of the hampering regulation that prevented them from diving even deeper into these “financial weapons of mass destruction” as Warren Buffet’s now popular quote termed them.
That was the nail in the coffin and what brought us to our sorry situation now.
Permanent Restructuring in Regulation? Please.
Now comes to the crux of the problem: regulations trying to clamp down on everything will not succeed.
Admittedly, it is true that given the nature of any regulation in distorting incentives in the market, such as the previously mentioned Basel requirements driving financial institutions into pursuing risky investments, you either choose to not regulate much at all, or regulate extremely heavily to prevent all the disastrous consequences of your regulation from occurring.
So what’s wrong with regulating now?
Nothing, of course, as long as Congress is willing to accept America losing its status as the world’s foremost financial superpower and see its banks bought out by the rest of the world, most likely Asia’s, since Europe’s banks are also in quite a bit of trouble (though they refuse to admit it/write it down for the most part).
Suddenly, in the current crisis, everyone seems to have forgotten the original reason there was such a push towards deregulation—because the rest of the world was beating our financial system with their looser rules and consolidated banks! America’s banks failed miserably in competition with the rest of the world because of the U.S.’s arcane rules and stifling restrictions on financial institutions. We had tiny, regional, high-cost and inefficient banks trying to compete with multinational conglomerations that came in and easily stomped our own quaint money-lenders and depository institutions.
Regulating now will still have a competitively deleterious effect now if we institute tight regulations, as have been floated currently. In case Congress failed to notice, the rest of the world is not following suit with the regulations. It is mouthing regulation, and will probably pass it, with massive concessions to the financial industry due to lobbying connections, but immediately upon it being politically convenient, will scramble to reverse it to keep the financial industry competitive globally.
Though, probably not before doing some sort of damage to incentives and setting us up for the next financial crisis. If you want the solution to financial crises and these boom-bust cycles once and for all, it’s simple: give the media and regulators a longer memory than roughly a decade.
Given the fact that the previous sentiment is more or less even more difficult to pricing these exotic derivatives, I suggest one watch what will be happening within the next year. My wager is that this “death of Wall Street” and this new “age of regulation” will be short-lived, at most.
