The Move Toward More Regulation

The air is heating up when it comes to the subject of banking regulation. The only advice I can offer those considering changes in the regulatory environment is “be careful.”

The main reason for this caution?

John Bogle, the founder and former chief executive of the Vanguard Group, wrote it very succinctly in the Wall Street Journal this morning: “There are few regulations that smart, motivated, targets cannot evade.” (See “Restoring Faith in Financial Markets: http://online.wsj.com/article/SB20001424052748703436504574640523013840290.html#mod=todays_us_opinion.)
Another reason for this caution comes from Mervyn King, governor of the Bank of England: “The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion.” Andrew Ross Sorkin provided this quote in the New York Times this morning. (See “Big, in Banks, is in the Eye of the Beholder”: http://www.nytimes.com/2010/01/19/business/19sorkin.html?ref=business.)

According to these two individuals, banks cannot be prevented from engaging in the types of activities that they really want to be engaged in and there is little that supervision can do to keep them from failing due to speculative activities.

In other words, bankers cannot be protected from themselves.

Why is this?

There are two very good reasons. First, in this Information Age, almost anything can be done with cash flows and risk, and regulators will always be behind the curve in trying to catch up with what is going on in the financial sector. After the financial crisis of 2008, this type of behavior has began again in the bigger banking organizations and I would argue that the regulators are already at least three- to six-months behind what these institutions are now doing.

Second, the financial community is truly global now and the flow of money (information) is very fluid. If something cannot be done somewhere it can always move elsewhere. Discussions about what the BRICs are doing (see the week long series of articles on Brazil, Russia, India, and China in the Financial Times this week) present one picture of how the world is continuing to shrink, financially. Another picture of the flow of funds throughout the world is captured in a recent research paper by MIT’s Ricardo Caballero which is quoted in the recent article in Time magazine: “Did Foreigners Cause America’s Financial Crisis?” by Stephen Gandel. (See http://www.time.com/time/business/article/0,8599,1954240,00.html.)

I would like to make one other point: many people continue to assume that behind active governmental policy and regulation are government officials and bureaucrats that are either more perceptive and talented than their private sector counterparts, or, are less self-serving than their private sector counterparts, or, are better placed to observe how the world works than are their private sector counterparts.

In my estimation, government officials and bureaucrats are not more capable or talented than their private sector counterparts and they are certainly not less self-interested. Furthermore, in my experience in government, they are not better placed or better informed about what is going on in the world. This latter point is one that the economist Friedrich Hayek made over and over again.

There is no research that I have seen that indicates that those that work for government perform any better than those that work in the private sector. If anything, the argument goes the other way: government cannot hire or attract people of the same quality that work in the private sector. Furthermore, there is no evidence to prove, in my mind, that people that work in government service are any less greedy for advancement or personal gain than are people that work in the private sector.

Finally, in their attempt to protect the society from “bad outcomes” the government has tended to err on the side of creating an environment for greater and greater private sector risk-taking. This has come in several forms. The obvious case currently is the “Greenspan put” or the bank bailouts that have created moral hazard and greater and greater amounts of risk taking. (See the article by Peter Boone and Simon Johnson in today’s Financial Times, “A Bank Levy will not stop the Doomsday Cycle”: http://www.ft.com/cms/s/0/e118fcc2-0461-11df-8603-00144feabdc0.html.)

Another case relates to the underlying emphasis on trying to maintain low levels of unemployment. This has created an environment that encourages risk taking in terms of increased financial leverage, maturity mismatching, and financial innovation. I have referred to the whole period from 1960 to the present as one in which the government underwrote an environment of credit inflation.

Furthermore, this continual effort to stimulate the economy has tended to put people back to work in jobs that were outdated or in industries that needed change. In order to protect the worker, the easiest and best approach was to put workers back into their old jobs. We see the consequence of this policy in the problems experienced in the auto industry, the steel industry, and many other areas that formerly represented the industrial base of America.

Last, special interest programs, such as housing, although designed with good intent, have ended up with several government agencies serving as the residual lender and insurer of mortgages. Over the past several years we have focused on Fannie Mae and Freddie Mac, but it is now obvious that we cannot ignore the FHA. (See the article by Nick Timiraos in today’s Wall Street Journal, “Souring Mortgages, Weak Market Put Loan Agency on a Tightrope”: http://online.wsj.com/article/SB20001424052748704586504574654710172000646.html#mod=todays_us_page_one.) This effort has resulted in the federal government becoming biggest player in the housing market, by a long shot!

To me, regulation of the banking sector should focus on two things. The first relates to capital requirements. They should be raised.

Second, there needs to be greater transparency and openness in transactions, deals, and balance sheets.

Almost every other kind of regulation that can be put on the books, in the words of John Bogle, can be evaded. We cannot protect the bankers from themselves. But, we can attempt to protect investors and other wealth holders by giving them more information about those institutions they want to invest in. But, like the bankers, ultimately we cannot protect these investors and other wealth holders from themselves.