Assessing the crash

on Sep 24 in Financial Market tagged by Trevor Hicks

I ran across a couple of articles today that reviewed some of the points I have made about the crash and the bailout.

First up, Matthew Yglesias sounds a skeptical note regarding federal regulation of banking compensation. You may have heard that the Obama administration is considering some regulation there much to the delight of Paul Krugman. I have blasted the idea of government regulation of private compensation in the past.  But I have to admit, Matthew makes a great point here:

Wh(y) doesn’t the market take care of this problem itself? It really seems like investors would be reluctant to deal with financial institutions that are organized this way. It seems like there was a reason the major investment banks were traditionally organized as partnerships—partnerships don’t have these incentives, and people should prefer to do business with institutions that don’t have these incentives. But the market’s not working like that. And it’s worth trying to understand why. If regulators start playing cat-and-mouse with compensation shenanigans, the mice are probably going to wind up winning. But if there’s some specific thing that’s preventing market discipline from adequately aligning incentives, we ought to be trying to find out what it is and what can be done about it.

This also echoes the point that Michael Lewis made in November of 2008 when he astutely identified the transition from the partnership model for Wall Street banks to publicly help corporations as a key enabler of the current crisis. Anyway, I support Matthew’s point that it’s plausible to imagine a scenario where government intervention may be able to correct a market failure regarding banking comopensation. But the reasoning behind the regulation I’ve heard so far is more of an “Underpants Gnomes” fig leaf for what is actually a way to punish the banking industry that goes like this.  ”Bankers made obscene amounts of money and then the banks crashed. Therefore, bankers making obscene amounts of money crashes banks and we need to outlaw it.” What Matthew is saying is, perhaps that’s true, but let’s make sure we think we understand the mechanism that leads from the facts to that conclusion before adopting some risky new regulation. Bear in mind, banking can be done anywhere. If we squeeze the banks too tightly in the US they will simply, and quietly I assume, shift more operations and management to Europe & Asia. I suppose many on the left would say good riddance.

The other article is from Mike Konczal pricking holes in the notion that regulation caused the crisis. On my old behind the corporate firewall blog, I’ve complained about the absurdity of the Basel capital regulations rating anonymous mortgage backed securities as less risky than mortgages originated and held by a bank. Konczal aptly points out, among other things, that just because the regulations permitted some odd balance sheet management practices doesn’t mean that the subsequent crash was caused by the regulation. The banks could still have been prudent with their money.  Good point, if a highway speed limit is 100 mph in a place where maybe only 60 is prudent doesn’t mean the government is at fault for your 95 mph crash.

There are still some important takeaways, though, that should make us cautious about layering on new rules and regulations. First is that we have no real reason to suspect that the regulators of the future will be any smarter than the regulators of the past. It’s not at all clear that the cause of the crash was insufficient regulation and that we just need more of it to prevent another one. Second, by relying on a regulatory approach that details very specific rules about handling certain assets or transactions we create an environment of reduced accountability for the entities being regulated. That is, it kind of forcefully outsources their own sense of prudence to the regulator.  And if they follow the rules and later crash, they have a pretty darn good argument for coming back with their hands out for bailouts. I think a regulatory environment that is less specific and more focused on principles and fiduciary duty, while having the drawback of being more ambiguous and difficult to prosecute, will also help to shift the accountability back from the regulators to the industry. Also, I think we need to accept the fact that failure will happen and, instead of squandering resources and efficiency in a futile prevention effort, try to craft a system that is more fault-tolerant and easier to reboot if I can draw some computer analogy.