Re-Regulate Financial Markets?--Posner's Comment

I no longer believe that deregulation has been a complete, an unqualified, success. As I indicated in my posting of last week, deregulation of the airline industry appears to be a factor in the serious deterioration of service, which I believe has imposed substantial costs on travelers, particularly but not only business travelers; and the partial deregulation of electricity supply may have been a factor in the western energy crisis of 2000 to 2001 and the ensuing Enron debacle. The deregulation of trucking, natural gas, and pipelines has, in contrast, probably been an unqualified success, and likewise the deregulation of the long-distance telecommunications and telecommunications terminal equipment markets, achieved by a combination of deregulatory moves by the Federal Communications Commission beginning in 1968 and the government antitrust suit that culminated in the breakup of AT&T in 1983. Although one must be tentative in evaluating current events, I suspect that the deregulation (though again partial) of banking has been a factor in the current credit crisis. The reason is related to Becker's very sensible suggestion that, given the moral hazard created by government bailouts of failing financial institutions, a tighter ceiling should be placed on the risks that banks are permitted to take. Because of federal deposit insurance, banks are able to borrow at low rates and depositors (the lenders) have no incentive to monitor what the banks do with their money. This encourages risk taking that is excessive from an overall social standpoint and was the major factor in the savings and loan collapse of the 1980s. Deregulation, by removing a variety of restrictions on permitted banking activities, has allowed commercial banks to engage in riskier activities than they previously had been allowed to engage in, such as investing in derivatives and in subprime mortgages, and thus deregulation helped to bring on the current credit crunch. At the same time, investment banks such as Bear Sterns have been allowed to engage in what is functionally commercial banking; their lenders do not have deposit insurance--but their lenders are banks that for the reason stated above are happy to make risky loans. The Federal Deposit Insurance Reform Act of 2005 required the FDIC to base deposit insurance premiums on an assessment of the riskiness of each banking institution, and last year the Commission issued regulations implementing the statutory directive. But, as far as I can judge, the risk-assessed premiums vary within a very narrow band and are not based on an in-depth assessment of the individual bank’s riskiness. Now it is tempting to think that deregulation has nothing to do with this, that the problem is that the banks mistakenly believed that their lending was not risky. I am skeptical. I do not think that bubbles are primarily due to avoidable error. I think they are due to inherent uncertainty about when the bubble will burst. You don't want to sell (or lend, in the case of banks) when the bubble is still growing, because then you may be leaving a lot of money on the table. There were warnings about an impending collapse of housing prices years ago, but anyone who heeded them lost a great deal of money before his ship came in. (Remember how Warren Buffett was criticized in the late 1990s for missing out on the high-tech stock boom.) I suspect that the commercial and investment banks and hedge funds were engaged in rational risk taking, but that (except in the case of the smaller hedge funds--the largest, judging from the bailout of Long-Term Capital Management in 1998, are also considered by federal regulators too large to be permitted to go broke) they took excessive risks because of the moral hazard created by deposit insurance and bailout prospects. Perhaps what the savings and loan and now the broader financial-industry crises reveal is the danger of partial deregulation. Full deregulation would entail eliminating both government deposit insurance (especially insurance that is not experience-rated or otherwise proportioned to risk) and bailouts. Partial deregulation can create the worst of all possible worlds, as the western energy crisis may also illustrate, by encouraging firms to take risks secure in the knowledge that the downside risk is truncated. There has I think been a tendency of recent Administrations, both Republican and Democratic but especially the former, not to take regulation very seriously. This tendency expresses itself in deep cuts in staff and in the appointment of regulatory administrators who are either political hacks or are ideologically opposed to regulation. (I have long thought it troublesome that Alan Greenspan was a follower of Ayn Rand.) This would be fine if zero regulation were the social desideratum, but it is not. The correct approach is to carve down regulation to the optimal level but then finance and staff and enforce the remaining regulatory duties competently and in good faith. Judging by the number of scandals in recent years involving the regulation of health, safety, and the environment, this is not being done. And to these examples should probably be added the weak regulation of questionable mortgage practices and of rating agencies' conflicts of interest and, more basically, a failure to appreciate the gravity of the moral hazard problem in the financial industry.

Comments

[Thomason]

All deregulation is partial deregulation. Has the Code of Federal Regulations become shorter?
No industry is unregulated in the U.S. Thus, to argue that deregulation of some industy sectors appears to have been beneficial and not in others is to gloss over massive differences between the regulated aspects, the extent of continued, i.e., "partial" regulation, and a host of other governmental and market forces.
Deregulation, that allowed banks to be brokers and brokers to be banks, was tangential to some of the current excesses. The long-standing practice of securitization of risks was extended to new types of instruments. The paper ended up being less valuable after issuance, or found to have been inaccurately valued or overvalued at the outset. The market contracted, the paper was written off, and a void in the current credit market opened, to be filled only when some new model or strategy emerges, which provides a market to handle these sorts of credit risks.

[Anonymous]

We also must remember that any deregulation or partial deregulation as sold politically is in fact merely a new set of regulations. These new sets of regulations can fail by being poorly structured, not just because they fall below the level of optimal regulation. The California energy regulation, for example, was manipulable because the companies providing the energy had more time and better people arguing to shape the legislation and then exploiting the loopholes. We have to consider this in areas like high finance when changing to new regulations ultimately gives more power to opportunistic elements of industry, who will have a higher learning curve.

That being said, the existent and tested measures of financial regulation (at least those which could be measured) did not have any impact on the subprime crisis. Capital requirements and provisions against certain lending practices could have been made, but that is assuming (disregarding entirely the costs) the men and women on Wall Street wouldn't be able to out maneuver these regulations.

And finally, Greenspan is unpopular today sure, but I doubt he was installed due to his following of Ayn Rand. If that does not speak to his competency, isn't this a petty point to raise, if not just an ad-hominem attack at an unpopular figure?

[konteyner]

Although one must be tentative in evaluating current events, I suspect that the deregulation (though again partial) of banking has been a factor in the current credit crisis. The reason is related to Becker's very sensible suggestion that, given the moral hazard created by government bailouts of failing financial institutions, a tighter ceiling should be placed on the risks that banks are permitted to take. Because of federal deposit insurance, banks are able to borrow at low rates and depositors (the lenders) have no incentive to monitor what the banks do with their money.

[Bob]

The problem with regulations these days is that they make gaming the system profitable. Enron was founded to game the energy trading regulations. When they ran into trouble they just kept on trying to game the system. Half the hype about Global Climate Change comes from people who hope to make money trading carbon or carbon offsets or some other new financial instrument.
Regulations also encourage gotcha business practices, where people get a rebate if they can remember to send in a form no sooner than t weeks after the purchase but no later than t+n weeks.

[Fresh Air]

Surely you have all read enough history to realize that "bubbles" will never go out of style. They are embedded in capitalism. Regulation or re-regulation only sets up additional obstacles around which speculators and financial agents must detour.

As to the current subprime situation, I don't think moral hazard plays an active role (perhaps a passive one). The explanation is far simpler. Bankers, on the whole, are timid people. They self-select for the comfort of the industry to some degree. Banks, due to their regulated nature, must conserve capital. Part of this conservation means selling off loans. As a twofer, originating and selling off loans also generates fee income. Fee income is the Holy Grail of today's investment/merchant/corporate banks. It entails lower risk, maximizes returns to shareholders, maximizes salaries to employees, and preserves risk capital. The hot potatoes are passed on, perversely, contra Posner's argument, because of capital regulation, not in spite of it.

Back to the timidity for a moment. Bankers tend to follow one another over the cliff over and over again. I need not recite the past five or six lending excesses over the last 20 years. The point is obvious that loans are made always assuming current conditions continue. This is why construction loans persist even in the obvious face of shifting markets; until the headwinds blow, the bankers are oblivious. Why? Because the First National Bank down the street is still lending. This gives the Second National Bank the comfort that it is doing the right thing. The reverse also happens, exacerbating downturns and causing recoveries to take longer. But the phenomenon is real.

So, yes, those lenders who actually held the crummy subprime paper made mistakes. But no one forced them to buy the loans with shoddy underwriting criteria. Ideally, the originators should owe clawbacks to the holders for poor performance. This would obviate the problem and eliminate the hazard of frenzied underwriting.

[Joe]

Hedge funds, which are far less regulated than the banks, are among the least affected by the credit crisis.

From:
http://www.foreignaffairs.org/20080312faupdate87277/sebastian-mallaby/blame-the-banks.html

"The most striking fact about the ongoing financial mayhem is that it is concentrated not in lightly regulated hedge funds but in more heavily regulated commercial and investment banks. It is banks that created subprime mortgage securities. It is banks that mispriced them. And it is banks that filled their own coffers with this toxic paper, losing hundreds of billions of dollars. A somewhat breathless March 31 Financial Times article proclaimed the closing of the worst month for hedge funds since the collapse of the infamous Long Term Capital Management in 1998. But the average fund tracked by the Chicago-based firm Hedge Fund Research declined by a mere 2.4 percent in March, bringing the cumulative fall for the first quarter of 2008 to 2.7 percent. By contrast, the bank-heavy financial services component of the S&P 500 fell 12.3 percent in the first quarter.

Hedge funds, for the most part, have weathered the storm remarkably well."

Looking at the price of gold and the Euro, its easy to see that Greenspan, and whatever political forces pushed him to inflate the dollar [Bush] are to blame.

[Michael Martin]

Don't quite agree here. None of the executives who worked at Bear Sterns over the past few years are going to be trusted with managing a large bank again. Any exercise of a Fed put, including the LTCM and Bear Sterns "bailouts," is going to be an ugly scenario that managers will rationally avoid.

The source of my disagreement with the need for re-regulation is probably hidden in the premise behind this statement by Judge Posner:

"There were warnings about an impending collapse of housing prices years ago, but anyone who heeded them lost a great deal of money before his ship came in."

Actually, the folks who didn't go along with the crowd didn't _lose_ money. True enough, they didn't make as much as the many who were willing to compromise their standards. But not making money and losing money are two different things.

The alternative of re-regulation presents the specter of a world in which government regulations become more subject to strategic political behavior rather than less. What we need are Taylor's Rules, not more Greenspans.

[Hypotheek Berekenen]

I must say, I like the ideas you are playing with. Your last blog about the budget airlines triggered me to leave an insight from Europe.

We see now that reliable airliners like KLM and others are winning market share again, somehow they find a way to lower there airfares a bit and keep the service on the right level. A fair combination, a good trade off and that could you reflect on many branches/industries/sectors or whatsoever.

HB

[Brian Davis]

IMHO, what we've been watching, experiencing, and paying for (and we'll pay more, lots more) out of Wall St ought to make a smart fella like Judge Posner sick to his stomach. Louie Brandeis, FDR and William O. Douglas didn't believe it was wise to let the brokers and bankers get too loose with other people's money. We have to count on leadership in the Executive Branch and Congress to set the example, to step on the brakes. Henry Gonzales was one of the best when he chaired House Banking through the S&L clean-up. Bill Seidman was pretty strict at the FDIC. Art Levitt ran a tight SEC. But it's like all the leashes began to unravel in '95 when Congress passed PSLRA over Clinton's veto. Then, in '98, they took the State securities commissioners out of blue-sky evaluation of IPOs. Shortly came a succession of sea-change financial de-reg measures. E.g., the banks couldn't have pulled off their off-balance-sheet contrivances without '99's Gramm-Leach-Bliley Act. I'm a free-marketeer 95% of the time. But the rewards need to be earned - value for value - not scammed. I have to believe even Ronald Reagan would have said that part of our social contract as Americans is an implicit obligation on the part of the well-to-do not to sell fanciful dreams to the less-well-off until they can earn and save enough to afford them.

[Winton Bates]

>
Isn't this just a case of guilt by association?

[Winton Bates]

I refer to the aside that you have long thought it troublesome that Alan Greenspan was a follower of Ayn Rand.
It seems to me that novelists and philosophers whom people associate with when they are young do not necessary have much relevance to their views in later life.

[Cycledoc]

No, it just guilty!

How many times will the American public pay for the experiment of deregulation. We need to protect these guys from doing harm to themselves--and our pocketbook.

[Daniel]

"When they ran into trouble they just kept on trying to game the system. Half the hype about Global Climate Change comes from people who hope to make money trading carbon or carbon offsets or some other new financial instrument"

a) global climate change is not 'hype,' b) the concern over it is not driven by people who will profit from carbon trading. It is a problem that scientists have been monitoring for around 50 years. The concern over it grew with an increased understanding of the underlying science and impact that human activity was having. Contrary to what you may have heard form Neil Bortz or Sean Hannity, it was not dreamed up in the last 10 years by fringe environmentalists and people trying to profit from it.

People will always try to game the system, deregulation allowed Enron and others in the energy sector greater ability to 'game it.' The partial deregulation that Posner referred to created an environment whereby actors who already had an incentive to game the system (get around regulations) had the ability to do so; deregulation did not create an incentive to game where one did not already exist. If regulations are stronger and enforcement more robust, the incentive to game will not go away but will be reduced by the likelihood of getting caught, and the direct costs of gaming will be increased because it will be tougher to get around the regs.

[Alex]

What about the lack of education for many Americans? Too many kids these days don't see the value in getting a college education and making themselves competitive in a global market. Most people today think the only way they can succeed in this country is to win the lotto.

[Jack]

Brian, I too would give a tip of the hat to Rep Henry Gonzales. I remember in the early days of Cspan seeing this plain spoken Representative ringing the alarm bell years before the S&L reform began. Bill Seidman too.

[Jack]

"You don't want to sell (or lend, in the case of banks) when the bubble is still growing, because then you may be leaving a lot of money on the table."

........ Every investor faces the equation between greed and risk, the actions of our financial institutions is indicative of either too little regulation, OR that they aren't playing with enough of their own marbles on the table. Every true businessman has to decide in his best interest whether to stay the course, expand, or even contract.

..... The "money changers in the temple" always have to be regulated and some of what we're going through is due to a roll back of Glass-Steagal that has allowed them to consolidate through out the nation and play in the insurance markets too. (I've not heard much about the mortgage insurance boys, were they wiped out in the first volley?)

[Jack]

Alex; Education! now there's an idea! I've long wondered why 12 years of schooling with fairly advanced math courses doesn't result in a HS grad understanding anything about personal finance or even something as simple as ROI or the future worth of a dollar. (Perhaps the way the buck is going we need not bother!)

Can we teach 17 year olds? or would it be better not to try, and offer adult education later in life? Perhaps 20 hours as a requirement for applying for a government backed loan?

[Robert]

Why do you find it troublesome that Greenspan WAS (the operative word here) a follower of Ayn Rand? Shouldn't it be more troublesome that he subsequently compromised his values in order to become a political social climber?

[Roberta Kelly]

Dear Honorable Posner:

Please study THE WEB OF DEBT. I know that the liars, cheaters, stealers/thieves and indeed, greed beyond our greatest imaginations is bounding and rebounding out of control, BUT,

And this is a BIG BUT ...

It is a learned bad action, greed.

Taught to those in the industry from the top. For example, I did not "input" the files that Wachovia wanted from my office of mortgage brokering. No, I would insist the representatives from World Savings (named at the time I was working in the industry) input the "STATED INCOME" loans. Why? Because it never appeared to me to be honest or legal and having worked for lawyers for about 20 years I was indoctrinated to the rule of law, so to speak.

So when an attorney who was formerly a lawyer for two of the Central Banks of the FED told me the entire sordid truth, I fully disclosed as the rule of law stipulates is the FULL DISCLOSURE law/s.

I went out of business!

Imagine the shock, not.

Why would anyone sell digitized debt as credit/money? At least why would anyone with a brain cell working or at the very least, an honest business person, sell credit/debt counterfeited as money?

And when I told my clients that it was worse than digital entries into both sides of the general ledger of the bank, canceling the "debt," a must action to co-create third-party loans to increase the HEDGE FUND gambling out of control.

My clients did not run away from me they literally disappeared. What sane human would not?

We The People of the U.S. get to provide wealth for those who already create it out of thin air. But we are the ones who provide the "real property asset," for absolutely NO NOTE and NO LOAN (i.e., THERE IS NO DEBT!).

Can't forget the fact (pesky laws) that LABOR MONEY is real and digitized debt is fraud. Hmmm, we provide "REAL" money for fraud. Wow, how dumb are we in America anyway!?

Now that is an intelligent choice alright. Let us all march as quickly as we can and give the real property to those who create digital debt as credit, sell it as money and then create illegal third-party loans to ensure Hedge Fund gambling in the global market to crash the system, and then what?

Please study AN ATTORNEY who has written her magnum opus, about our "monetary system." Maybe we can still hope enough "JUDGES" awaken to the reality that the U.S. is not going to look anything close to Kansas anymore once this grand theft shakes down and out, over the next 2-4 years?

Let us do the counting for those who appear not to count numbers in an honest fashion. No note, no debt. Charge the bankers, too, for the laws which have been broken beyond anything the sane mind can comprehend.

Thank you for your time.

http://www.webofdebt.com

Respectfully submitted, Roberta Kelly

[ctw]

"[Those] whom people associate with when they are young do not necessary have much relevance to their views in later life."

According to wikipedia, the association with Rand continued actively into at least the "young" Greenspan's 40s, passively until her death. In any event, it's not being a "follower" in the sense of "reader and subscriber to the theories of" that should be most bothersome, it's being one in the cult sense.

"... a follower of Ayn Rand. Shouldn't it be more troublesome that he subsequently compromised his values ..."

Perhaps these are related at the psychological level; eg, susceptibility to being both the subject and the object of hero worship?

- Charles

[Roberta Kelly]

Which regulation, exactly? The one that was modeled after Citi in Dubai, 1948 - seemingly to implement the credit crises, I mean wealth for American homeowners in the Aught Years.

[Dan Kasper]

Richard,

I agree that deregulation has no always been an "unqualified success" and that further regulatory changes could improve the performance of deregulated industries. Likewise, I agree that anti-government (Ayn Randian) ideologues have failed to recognize or undertake legitimate activities that can only be effectively carried out by governments. But I nonethless submit that few, if any, social policies can be fairly described as "unqualified successes." To paraphrase Harold Demsetz, the right comparison is not perfect regulation vs. imperfect markets but is imperfect deregulation vs. imperfect regulation. Thus, I think Becker is closer to the mark in his comparative analysis of the performance under deregulation.

In addtion, your reliance on the purported effects of airline deregulation to buttress your case for increased financial regulation strikes me as substantially misplaced. While there is some connection between deregulation and one aspect of what you perceive as "service degradation" -- specifically, much higher average load factors on flights -- that change was fully anticipated and discussed at some length in the academic and political debates preceding the passage of the Airline Deregulation Act. Thus, it was well-recognized that load factors prior to deregulation had been artifically suppressed by CAB regulatory policies that induced carriers to operate with only about 55% of their seats filled, compared to 80% last year. In short, the increase in load factors ("crowding") in the post-deregulation period largely represents more efficient utilization of expensive assets that was one of the policy's goals.

Finally, your reliance on airline deregulation is misplaced for another, more important reason. As I explained in my response to your "airline delays" blog posting of last week, increased delay is primarily caused by the twin failures of government to (1) expand infrastructure capacity (i.e., runway and the air traffic control system capacity) sufficiently to meet demand and (2) to allocate existing capacity in an econonomically efficient manner. Those are failures of government to respond to the growth in traffic spurred by deregulation, not the failure of deregulation policy.

[Dan Kasper]

Richard,

I agree that deregulation has no always been an "unqualified success" and that further regulatory changes could improve the performance of deregulated industries. Likewise, I agree that anti-government (Ayn Randian) ideologues have failed to recognize or undertake legitimate activities that can only be effectively carried out by governments. But I nonethless submit that few, if any, social policies can be fairly described as "unqualified successes." To paraphrase Harold Demsetz, the right comparison is not perfect regulation vs. imperfect markets but is imperfect deregulation vs. imperfect regulation. Thus, I think Becker is closer to the mark in his comparative analysis of the performance under deregulation.

In addtion, your reliance on the purported effects of airline deregulation to buttress your case for increased financial regulation strikes me as substantially misplaced. While there is some connection between deregulation and one aspect of what you perceive as "service degradation" -- specifically, much higher average load factors on flights -- that change was fully anticipated and discussed at some length in the academic and political debates preceding the passage of the Airline Deregulation Act. Thus, it was well-recognized that load factors prior to deregulation had been artifically suppressed by CAB regulatory policies that induced carriers to operate with only about 55% of their seats filled, compared to 80% last year. In short, the increase in load factors ("crowding") in the post-deregulation period largely represents more efficient utilization of expensive assets that was one of the policy's goals.

Finally, your reliance on airline deregulation is misplaced for another, more important reason. As I explained in my response to your "airline delays" blog posting of last week, increased delay is primarily caused by the twin failures of government to (1) expand infrastructure capacity (i.e., runway and the air traffic control system capacity) sufficiently to meet demand and (2) to allocate existing capacity in an econonomically efficient manner. Those are failures of government to respond to the growth in traffic spurred by deregulation, not the failure of deregulation policy.

[Jake]

Judge Posner writes: "The correct approach is to carve down regulation to the optimal level but then finance and staff and enforce the remaining regulatory duties competently and in good faith."

Woe unto His Honor. To all appearances, he has forgotten Hayek's teachings.

Come on, folks. How can the notion of an "optimal level" of governmental regulation be reconciled with our Declaration of Independence?

[Alex]

Maybe I'm being naive, but if we are bailing out banks because we are worried about the consequences of letting them fail, then we must need a more robust bankruptcy mechanism for banks. We might need better regulation too, of course, but there is plenty of attention to that, and I haven't seen any attention on the former.