The Regulation of Banks and Financial Markets: One Year Later

The papers and the news broadcasts over the last week have been filled with stories about the failure of Lehman Brothers and the need to re-regulate the financial system. The second-guessing has been enormous on the failure of the federal government to come to the aid of the troubled investment banking firm, especially when put into the context of the bailout of AIG and the help given to other investment banks and commercial banks.

Furthermore, the report card on the government’s effort to re-regulate the financial system seems to be hovering between D and F! The consensus review of what has happened over the past year is: nothing!

In terms of letting Lehman Brothers go, let me just say that the second-guessing is a fun game and provides a diversion for journalists and makes good reading but is not very productive. This is the problem with decision making under very stressful conditions with very little information on what the potential outcomes of actions might be.

For one thing, very few people in the summer of 2008 even considered that the financial might be on the verge of collapse. That is what makes situations risky, the lack of knowledge of what might happen in the future. Yes, we can talk about Black Swans and so forth, but the probability of a severe financial crises occurring is a very unlikely event and business is not conducted on a “what-if-the-worst-happens” scenario. Second, no one has “experience” in dealing with a very serious financial crisis. It is entirely different studying previous examples of financial crisis, but to have to deal with one face-to-face is an entirely different matter. Third, the biases and prejudices and world views of the individuals in charge of making these decisions play a role in how people respond to a crises and no one, before-the-fact, can make an adequate prediction of how leaders will perform in a “once-in-a-lifetime” situation.

The financial system is still functioning and the economy seems to be working its way out of a deep recession. Could things have been done better? Yes. Could things have turned out worse? Of course. But, we seem to have muddled through the real crisis period. Hopefully, we will not have a second shock wave that sends us back into another panic mode.

In terms of re-regulating the financial system, I have several opinions I would like to share. First, to try and re-regulate a financial system immediately after a financial crisis occurs is, in my mind, not the thing to do. For one thing, you don’t really know what happened or what caused the crisis and to rush to judgment is often to rush into folly. Furthermore, villains are usually identified that may or may not really be the “bad guys” that need punishment or controlling. Powerful politicians or government officials impose their own biases and prejudices into the discussion and they are not always the best forces to design a new regulatory system. Also, new regulatory systems that are quickly put into place following a debacle are often designed to “fight the last war” and are not really appropriate for the environment the world is moving into.

The problem with not moving to re-regulate relatively quickly is that the movement to re-regulate loses its urgency.

My second concern has to do with the causes of the financial crisis. Since the financial collapse has to do with financial institutions and financial instruments, people look first at the individuals running these organizations or dealing in these instruments for the culprits of the crisis. The problem I have with this is that the leaders and practitioners of finance are responding to the economic and financial environment that they work within. The macro-incentives that exist within an economy are oftentimes created by others with very little insight into the incentives that they are actually setting up. The “others” I am talking about are, of course, our governmental leaders. Who created the macro-environment that produced the incentives for individuals to act in the way they did? What about Mr. Greenspan and Mr. Bernanke and the credit inflation that they spawned in the early part of this decade? What about the Bush 43 administration that created the huge fiscal deficits that resulted in a more than 40% decline in the value of the dollar?

The federal government represents more than 25% of GDP in the United States and with this impact on economic activity as well as through the rules and regulations it creates, the government has a very pervasive influence on the incentives that individuals and businesses have to respond to and operate within. The leaders in the federal government go free of blame while the people that have to live within the environment these leaders created must bear the burden of shame and guilt for the financial crisis that resulted.

My concern here is that maybe the re-regulation of the financial system is not the entire problem. My concern here is that people do not really understand who created the environment in which a financial meltdown could occur. Maybe better government policy making is in order, but maybe that is too much to ask for.

Finally, I would like to argue that financial types, human beings, are going to continue to innovate in the future and there is ultimately very little that governments or regulators can do to prevent financial innovation from taking place. (Human beings, by their very nature are problem-solvers and innovators.) Financial innovation has existed throughout history. Finance, really, is nothing more than information. That is one reason why financial innovation was able to explode beginning in the 1990s with the advancements in computer technology. The computer just allowed people to “slice and dice” massive amounts of information flows more efficiently and more quickly. (Even one of the staunchest proponents of behavioral finance, Robert Shiller, proposes using computer assisted financial innovation to take contribute to the evolution of new financial markets and instruments: see his books “Macro Markets” and “The New Financial Order.”) The whole idea of “information markets” builds upon models of financial innovation and how these models can be extended to other markets using massive new data base systems and the advanced computing power that is available in the ever-evolving world of information technology.

There must be oversight of the financial system and this oversight must be accompanied by increases in the openness and transparency of financial transactions and financial reporting. The innovation, in my mind, cannot be controlled. Therefore, we (business leaders, investors, and regulators) must also have more and more information available to us on a more timely basis in order to try and understand what is happening and to react to it. This, to me, is the world of the future.

It is this world of the future that must be considered in any effort to re-regulate the financial system. Fighting the last war is not going to produce the regulatory system we need. Ignoring the incentives that government creates is not going to produce the regulatory system we need. Regulations to produce specific “results” will not work. To my mind, it is not all bad that the rush to re-regulate or to develop a new regulatory system has stalled or been put on the bad burner.