April 28, 2008
Greater Regulation of Financial Markets?
Greater Regulation of Financial Markets? Becker
The major deregulation movement of the past 100 years started with the Ford and Carter administrations in the 1970s, and continued through the Reagan years. This movement came to an end with the passage of the Americans with Disabilities Act of 1990 under the administration of George W. Bush. Since then some sectors, such as labor markets and product safety, have been regulated much more extensively, while others, including commercial and investment banking, have had no further declines in the extent of regulation. Despite the considerable and tangible successes of this deregulation movement, the pressure is intense to significantly increase the regulations affecting consumer safety, the introduction of new drugs, and especially financial markets.
The 1970s saw a bipartisan reduction in the regulation of airline travel, trucking, security exchanges, and commercial banking. Measures of the success of this deregulation include sharp declines in the cost of air travel and of shipping goods by truck, huge reductions in commissions on stock transactions, and higher interest rates on bank deposits. Not only has no serious attempt been made to re-regulate these activities, but also European and many other nations on all continents have copied the American deregulation of airlines and securities.
The impetus to tighter regulations varies from sector to sector, although there is a growing belief that many activities are insufficiently regulated. Obviously, the current turmoil in the financial sector is stimulating many proposals to regulate extensively various types of financial transactions. Yet it is not obvious that the problems in the financial sector resulted mainly because of insufficient regulation. For example, commercial banks are probably the most heavily regulated group in the financial sector, yet they are in much greater difficulties than say the hedge fund industry, which is one of the least regulated industries in the financial sector. Banks participated very extensively in originating mortgages, including subprime mortgages, and in buying mortgage-backed securities, and so they are suffering from the high foreclosure rates, and the sharp decline in the market value of these securities.
One reason why extensive regulation of commercial banks did not prevent many banks from getting into trouble is that bank examiners became optimistic along with banks about the risks associated with mortgages and other bank assets because the market priced these assets as if they carried little risk. It would run counter to human nature for regulators to take a skeptical attitude toward the riskiness of various assets when the market is indicating that these assets are not so risky, and when originating and holding these assets has been quite profitable. One can expect regulators to mainly follow rather than lead the market in assessing riskiness and other asset characteristics.
To some extent that was also true of the Fed's behavior during the past few years. I believe that Alan Greenspan is right in claiming that the main cause of the housing boom was not the Fed's actions but the worldwide low interest rates due to an abundant world supply of savings. The demand for very durable assets like housing is greatly increased by low interest rates. Still, the Fed seems to have contributed to the booming demand for housing and other assets by keeping the federal funds rate artificially low during the boom years of 2003-05.
In evaluating the need for greater financial regulation, one should also not forget that the American economy greatly outperformed the European and Japanese economies during the past 25 years. Might that not be related in part to the fact that the United States led the way with major financial innovations like investment banks, hedge funds, futures and derivative markets, and private equity funds that were only lightly regulated? An infrequent period of financial turmoil may be the price that has to be paid for more rapid growth in income and low unemployment. Rapid income and employment growth might be worth an occasional period of turmoil especially if they do not lead to prolonged slowdowns in the real part of the economy. So far the effects on GDP and employment have not been severe, although the financial distress is not yet completely over.
Nevertheless, a few important regulatory changes are probably warranted. For the first time the Fed allowed investment banks access to its federal funds window, and the Fed guaranteed $29 billion worth of mortgage-backed assets to induce J.P. Morgan to take over that investment company. Since these types of Fed actions would likely be repeated in the event of future financial turmoil, investment banks would have an incentive to take on additional risk since they can reasonably expect to be helped out by the Fed in the future. For this reason it might be desirable for the government to impose upper bounds on the permissible ratios of assets to equity held by investment banks. The ratio of assets to the equity of the five leading investment banks did increase greatly from about 23 in 2004 to the highly leveraged level of 30 in 2007.
Other regulations of financial institutions may also be merited, but elaborate new regulations of the financial sector would be counterproductive. For example, the Fed has proposed limits on how much mortgage interest rates can exceed the prime rate for low-income borrowers with poor credit ratings. This would be a foolish intervention into the details of credit contracts that have all the defects of usury laws.
The financial sector has served the economy well by managing, dividing, and pricing different types of risks in the economy. It would be a mistake if Congress and the President allow the present financial turmoil to panic them into inefficient new financial regulations.
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.