What was the problem with financial regulation?

Here is my NYT column from today.  Excerpt:

In short, there was plenty of regulation – yet much of it made the
problem worse. These laws and institutions should have reined in bank
risk while encouraging financial transparency, but did not. This
deficiency – not a conscientious laissez-faire policy – is where the
Bush administration went wrong.

…the Bush administration’s many critiques of regulation are
belied by the numbers, which demonstrate a strong interest in continued
and, indeed, expanded regulation. This is the lesson of a recent study,
“Regulatory Agency Spending Reaches New Height,” by Veronique de Rugy,
senior research fellow at the Mercatus Center at George Mason
University, and Melinda Warren, director of the Weidenbaum Center Forum
at Washington University.
(Disclosure: Ms. de Rugy’s participation in this study was under my
supervision.) For the proposed 2009 fiscal budget, spending by
regulatory agencies is to grow by 6.4 percent, similar to the growth
rate for last year, and continuing a long-term expansionary trend.

For the regulatory category of finance and banking, inflation-adjusted
expenditures have risen 43.5 percent from 1990 to 2008. It is not
unusual for the Federal Register to publish 70,000 or more pages of new
regulations each year.

…The biggest financial deregulation in recent times has been an implicit
one – namely, that hedge funds and many new exotic financial
instruments have grown in importance but have remained largely
unregulated. To be sure, these institutions contributed to the severity
of the Bear Stearns
crisis and to the related global credit crisis. But it’s not obvious
that the less regulated financial sector performed any worse than the
highly regulated housing and bank mortgage lending sectors, including,
of course, the government-sponsored mortgage agencies.

There is much more at the link.  Mark Thoma adds comment.  So does Arnold Kling.


A number of blogs have pointed to the amazing INDYMAC: MY EXPERIENCE. One snip from that:

I finally finished my own airport parking lot appraisal report in late March, the same week that the Bush Administration laid off most of the OTS examiners. I don’t know which event precipitated my termination. My appraisal of the airport parking lot estimated the stabilized value at $37 million in year 2003 and the value upon completion as $31 million in 2002. These appraised values were considered insufficient to support the $30 million loan.

We know that the Bush admin has been selective in its enforcement of regulation (see also the EPA). I think that might be the bigger story.

I'd like to take a second to offer hysterical laughter directed towards the people who lost their shirts investing in home loans of all things. If you lose everything on home loans, it's time to throw in the towel.

High rates of leverage is a statement that you don't know what they hell you are doing, whether you realize it or not.

So do generic calls for "more regulation." They are saying "We have a rat problem, therefore stuff more money down that hole!"

Both of these signal the same thing. "We have no idea how good what we are buying is, but more must be better."

SA, I think you're misreading what Tyler wrote.

The point is, most people who saw trouble coming anticipated that it would be (unregulated) hedge funds triggering it, à la LTCM in 1998. While some hedge funds have indeed blown up, this has been of little consequence to the rest of the financial system. The cascading slow-motion train wreck we are experiencing has originated not from within the unregulated sector, but from the traditional financial sector deciding to become sorcerer's apprentices. Case in point, there were few companies in existence more tightly coupled to government regulations than Fannie and Freddie.

Again I am surprised to find discussion of regulation without a single mention of the ratings agencies. Weren't they the key crux point, and don't they remain so?

Being paid by securities issuers, and preparing their ratings in collusion with those issuers, they failed to accurately rate the securities.

If they had rated them accurately, it would been harder and more expensive to sell those securities. Which would have made it harder and more expensive--or even impossible--for loan issuers to issue the underlying loans.

What about regulations barring ratings agencies from accepting money from issuers? Or at least, a cigarette-type warning on each rating paid for by an issuer? Would this create a market for less-conflicted ratings?

True, the ratings are free at this point. But they might also be useless.

This is the kind of regulation that supports a truly free market, in which all (or at least more) information is known.


Point taken.. I misread it.. apologies

"Who will regulate the regulators?"

Goes back to why we have three branches of government. I understand some of those energy regulators are in trouble with the judicial branch right now.

"In the meantime, if you hear a call for more regulation, without a clear explanation of why regulation failed in the past, beware. The odds are that we’ll get additional regulation but with even less accountability and even less focus on solving our very real economic problems."

I'm confused by this. What is regulation without accountability? Sounds like no regulation, or pseudo-regulation. Either people go to jail, or they don't. Either losses are absorbed, or they aren't.

"Under these circumstances, the real issue is setting strong regulatory priorities to prevent outright fraud and to encourage market transparency, given that government scrutiny will never be universal or even close to it. Identifying underregulated sectors in hindsight isn’t a useful guide for what to do the next time." ---Tyler Cowan


1) Nobody really knows what the right degree of regulation should be of a very complex, ever changing web of financial institutions that have --- over the last 30 years or so --- both helped and hindered global economic growth.


2) More specifically, the combination of deregulation across numerous industries, not just financial ones, has helped the US economy move quickly from an industrial-based system to a knowledge-based system based on knowledge and ideas . . . but, simultaneously, has repeatedly dislocated the economy because of the excessive risk-taking and poor management of risk and allocating capital efficiently that have marked many of these financial innovations.


3) Consider the lengthy list of dislocations:

* The stock market balloon of the 1980s and then the bust on Black Monday in late 1987, the biggest one-day decline in US stock-market history. The balloon was accentuated by promises of brokerage firms that, thanks to computers, they would swiftly move the investments of their clients that were falling a given percentage over to the bond market. The reality: only a few big investors were helped this way.

* The S&L (Savings and Loan) fiasco of the late 1980s, which required a government bailout.

* The dot.com ballooning stock market of the 1990s --- balloons built into the nature of capitalism, it seems (best explained by Hyam Minsky, and not dead Austrian economists) --- and subsequent crash.

* The Long Term Capital Management hedge-fund fiasco, with tens of billions lost even though the hedge fund was run by two Nobel Prize-winning economists with 25 Ph.D. economic analysts. Another government rescue needed (1998). (True: hedge funds have, more recently, done better than commercial and investment banks, never mind independent mortgage-brokers, in staving off a fall in capital and profits . . . a sign, again, of the complexities of financial management and the problems facing regulators.)

*The subsequent accounting scandals entangling firms like Enron, World.com, and the like that, it seems, did little other than manipulate balance sheets. The real shocker was that so-called outside accounting scrutiny of corporations and financial institutions turned out to be something of a joke, with these accounting agencies free, simultaneously, to work out lots of sweetheart deals with those they were scrutinizing . . . not least, thanks to changes in accounting regulations of the late 1990s.

* The head-spinning innovations in "fee structures" that mark almost all the financial sectors of the US economy . . . to the point that credit-card holders, thinking they may have to pay, say, 20% max interest rates on short-term loans may in fact be paying five times that rate.

* The gigantic flaw that followed: the subprime innovation, carried out in a sort of Ponzi-scheme by independent mortgage firms (another innovation), with commercial and investment banks then getting involved --- hey, who cares about credit-analysis, just pass on the risky paper to the buyer down the road
-- and then excessive snowballing of all this on a vast global scale.

* The subsequent bust of this subprime hoopla, and the worse consequence, a huge credit-squeeze . . . credit the life-blood of our economic system. Then quickly followed by the failure of certain key brokerage firms and the near default of Fannie and Freddie, both necessitating rescue by the US government and Federal Reserve, even as the same was true of certain key commercial and investment banks . . . with more bailouts certain to occur.

* And, if we're to believe Alan Greenspan --- a follower and true-believer of Ayn Rand ---- the speculative causes of the huge upsurge in oil prices starting last winter, with its dislocations, followed by the subsequent collapse starting in late July.


3) All this has occurred in the US, with world-wide repercussions.

I pass over, just in mentioning, nothing else, the Asia financial meltdown of 1997-98, with (interestingly) China and India --- both not deregulating their financial markets --- the only countries not to have been badly hurt.

No, I am not recommending Chinese or India-style regulations here. That would be absurd, even loony.


4) Let's leave aside, too, the underlying causes of these financial excesses and subsequent crashes --- analyzed effectively by Hymam Minsky, a great economist who had been a former stock-broker and investor --- and look at the mix of regulations and deregulations in finance that mark this country's current combination.

On Minsky, see: http://en.wikipedia.org/wiki/Hyman_Minsky

Cowan, in his article, does not mention the kind of appointments that the Bush-W administration has made to head most of our financial regulatory agencies . . . virtually one and all headed by political hacks and incompetents, with little or no interest in effectively carrying out their regulatory role.


The causes of such bungling may be numerous --- not least, just plain incompetence, with the Bush administration specializing in way too many outrageous appointments (though not, fortunately, at the top in the Treasury department or in Bernanke's nomination to take over the Federal Reserve).

Just as the private sector needs highly qualified managers, so does the public sector --- and that includes, note, the military, where the appointment of General Petraeus, after nearly 4 years of disastrous occupational policies in Iraq, radically and fairly quickly changed the situation on the ground in that country.

Political ideologues opposed to regulation, regulators who identify with the interests of the industrial firms --- like the accounting firms who had sweetheart deals with the firms they were supposedly monitoring --- and hack incompetents will botch things up just as much in the public sector as they will in the private sector.


5) The conclusions?

Nobody really knows the right degree of regulation in the financial sectors, not least because the rapid innovations --- facilitated by the Internet and all sorts of excessive capital running around the world as China and India and Russia and Middle East oil-rich countries boom (with no effective internal financial markets for investment and hence huge outflows into the US and the EU) --- are hard to keep up with.

But with do need to find ways to make all these financial institutions more transparent and accountable --- the latter meaning to their investors, borrowers, and the public in general.

And that requires an administration and a Congress that don't seem to toady to special interest money and ideologies opposed, in rigid principle, to effective regulation.


6) On a wider political level, the new populist backlash --- with 80% of the US public repeatedly saying our country is on the wrong track and suffering from a very bad or fairly bad economy --- has been fueled by these financial dislocations, one after another, and to the point that it seems punched out mentally.

Add in the rapid growth of income inequality --- not unrelated, to put it mildly, to these financial innovations and instabilities and outright shenanigans at times --- and all of us should be geared to deal with a soured American public view of our economy until far more confidence in our economic, financial, and political elites is restored.

Otherwise, ladies and gentlemen, it's a repeat of the 1790s Whiskey Rebellion, the Jacksonian populist onslaught on new financial institutions, the populist agrarian rebellion of the late 19th century against Wall Street and industrial giants, the muckraging surge that followed, the Progressive breakthrough that accompanied it, and the 1930s more radical turn in the Great Depression.

And restoring confidence means that people like us posting in this thread are again convinced that our financial institutions do what they are supposed to all the way back to Adam Smith: allocate capital efficiently and managed financial risk-taking properly.


Michael Gordon, AKA, the buggy professor

I also woudl like to SECOND Darryl Stoflet. If I'm reading the tables right, Tyler's numbers are extremely misleading. Between 2000 and 2007 (Bush's years in office, before the crisis became obvious), regulatory spending in finance increased by 5%. If you count the Clinton years, and the up-tick in 2008 budget (after it was obvious we were in trouble) -- then you get a 43% increase. That is really, really, really misleading.

I was struck that the professor didn't mention regulatory capture. This has gummed up the whole process, and driven a good bit of the cost of regulation.

"The NY Times column is disingenuous to say the least. The case being made as stated in the opening sentence:
'There is a misconception that President Bush’s years in office have been characterized by a hands-off approach to regulation..'"

Wasn't it Bush who tried, but failed to remove oversight of Freddie and Fannie from Congress? Seems if he had succeeded, a lot of this crisis could have been averted.

I think we are in desparate need of reform
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