Financial reform and why it is hard to blog

by on April 6, 2010 at 7:53 am in Economics, Law | Permalink

Paul Krugman writes an Op-Ed on where the political debate is at and I agree with most of his points.  Of particular importance is this one:

So what the legislation needs are explicit rules, rules that would force action even by regulators who don’t especially want to do their jobs. There should, for example, be a preset maximum level of allowable leverage – the financial reform that has already passed the House sets this at 15 to 1, and the Senate should follow suit.

I favor this but I nonetheless think it remains problematic.  The more binding the leverage restrictions, the more banks and other intermediaries may try to recreate implicit leverage off the balance sheet.  (This is one reason to push for decentralized market monitoring, though I am not suggesting exclusive reliance on that.)  It's fine to call for maximum transparency, but mostly that's just wishing for a different world.  Activities off the balance sheet are off the balance sheet for a reason and it is hard to squeeze many of them into traditional accounting conventions.  Nor should we try to ban off-balance sheet banking, as it would happen somewhere — both geographically and in some corner of the financial sector – and indeed many of these transactions limit rather than raise risk.

The upshot is that managing off-balance sheet risk requires an ongoing, hammer and tongs approach.  There isn't any "once and for all" solution to banking regulation and the harder we try to find one probably the more we will end up relying on regulator discretion and judgment.

Bank regulation is a tough slog, it depends on the quality of the bureaucracy and the periodic attention of a somewhat responsible legislature, "toughness" can be counterproductive, the historic periodic of regulatory "easiness" relied on cartelization and near-automatic profits, and it is like a chess game whereby the private sector eventually finds a way around most of the binding regulations.

And now we can return to why financial reform is hard to blog.  There's always a new proposal and a big tizzy over the particular contents of that reform.  Whatever one thinks of the specific suggestions, I keep returning to the notion that the quality of the regulators — most of all Congress — truly matters.

How many times can one say that?  How many times can one think that and run away in fear?

Arnold Kling has good remarks on transparency.

Andrew April 6, 2010 at 8:16 am

So, by limiting leverage that guarantees everyone can pay their bills?

I thought only the printing press could guarantee that.

DanC April 6, 2010 at 9:02 am

Krugman blames republicans for a bill written by Senator Dodd?

Krugman ignores how Rubin helped expand the “shadow” banking system?

Krugman ignores the issue of regulatory capture.

Why do politicians like regulation? The more regulations you have, the more money you have enter the system to influence the political process.

For those who scream about money and special interests in politics why do you ignore that government regulation is the driving force behind the growth of money in politics?

The more complex the regulations, the more room you leave politicians to cut deals for favored firms and the more incentive you leave firms to find competitive advantages in the cracks.

The hammer and tongs method that Tyler mentions quickly becomes the contribution and favors method in our political system. Full of hidden taxes, reduced efficiency, and a self serving game between regulators and the regulated.

E. Barandiaran April 6, 2010 at 9:26 am

Tyler, let me say it again: monetary and financial systems have ALWAYS been controlled by governments for the simple Willie Sutton reason that that’s where the money is. Private banks and other financial institutions have always been lenders of first resort or last resort or any point in between to governments, and more importantly, they still are lenders to governments (either directly by transferring funds to government or by complying with government instructions about what to do with the funds they have mobilized). Therefore, any serious discussion of monetary and financial regulation must take place in the context of a particular system of government. You cannot assume that the government will change to accommodate your view of how the monetary and financial systems must work.

Given the current US government system, and in particular his decline into a Banana Republic-type of system, I suggest that you change your research agenda from reforming the monetary and financial system to reforming the government system. As shown by the history of Argentina in the past 80 years, you can change as much as you want the monetary and financial systems, but as long as you have the same BR system of government, they will fail to support the expansion of the private economy.

T. Shaw April 6, 2010 at 9:37 am

FDIC-insured banks and Fed-supervised bank holding companies have been subject to leverage and risk-based capital requirements for decades.

Orwell: “Early in life I had noticed that no event is ever correctly reported in a newspaper.”

Krugman is consistently wrong and a fountain of proofs for Mr. Orwell’s maxim.

Krugman and that idiot senator (I repeat myself) Dodd have not identified the cause of all this pomp and circumstances and their moronic legisaltion will do nothing to forestall a future debacle.

Look at FIRREA. Look at FDICIA. Look at Sarbanes-Oxley.

They’ve got nothing working between their ears.

Here are two differences (I think) between the Swiss regulatory model and ours. One, various financial ratios/benchmarks are codified in statute. Two, violations of such statutes resulting in material losses to institutions result in criminal trials and the convicts serve in the same prisons as the Swiss equivalent of Charles Manson.

Even better. I understand that in China, the officers and employees of a failed bank would be taken outside and shot. That may work.

josh April 6, 2010 at 10:07 am

“So … you’re saying it’s hopeless, right? :)”

In all seriousness, why the smiley-face?

mark April 6, 2010 at 11:23 am

Good post. Leverage limits are the key. Also clear rules are key. Bureaucratic discretion is bad and unreliable. There is no way that salaries for regulators will ever be competitive with salaries of the regulated so there is a permanent talent gap to regulation.

To address your concern about leverage limits being gamed, you need a supporting feature, a layer of debt that the regulator can convert to equity to avoid insolvency. That will provide a built in remedy for the gaming risk.

roversaurus April 6, 2010 at 12:30 pm

This is comical.

What the heck is the PURPOSE of your reforms?
To prevent banks from failing? Yeah, right, you’re trying to legislate away failure?

Oh, the serious people really want to prevent massive bank bailouts. The problem is that the serious people were the only ones who WANTED bank bailouts. The Tyler Cowen’s of the world CAUSED the very problem they are trying to regulate away.

It’s like the scene in blazing saddles where the guy holds a gun to his own head and says “One move and the n***** gets it”

NONE of this regulation will work. What you need to do is stop bailing out failure.

xysmith April 6, 2010 at 4:18 pm

This is silly. Complex rules will fail. A simple rule will solve all the problems:

Anyone who:

1) Is employed in the financial industry and earns directly or indirectly, more than <some X multiple of the median wage>.
2) Owns more than Y percent of a financial company.
3) Is a key officer in a financial company.

(Define X & Y suitably.)

Are not shielded by the corporate veil in the event of adverse business conditions.

In other words, if the government has to step in to save the institution, the first step is to not save the people caused the problem.

Altereggo April 7, 2010 at 12:02 am

It’s amazing how so many economists begin policy advice by saying “first, assume a perfect and infallible institution.”

Krugman believes that laws can be enforced in a system that doesn’t act to execute them. How long ago was that idea discredited?

We’ve been too busy partying with John Law to read Montesquieu, apparently.

how to get your ex boyfriend back April 7, 2010 at 2:38 am

Well its a good-faith effort to do what needs to be done but it will create a system that is highly dependent on the wisdom and good intentions of government officials.It sounds good in theory that ethical standards should encourage market activity more than they restrain them.

ugg gissella April 9, 2010 at 12:25 am

No rose without a thorn.

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