Treading A Fine Line When It Comes To Setting New Regulations

Interesting article from the NY Times on the need for better set of regulations for the financial industry, as well as various aspects of past financial crisis:

From the NY Times:

Either Barack Obama or John McCain could well become the first U.S. president since John F. Kennedy to be elected during a recession, not to mention a financial crisis. What sort of nation will the winner inherit? Although the string of bank failures and panic on Wall Street has overtones of the 1930s, the risk is less a repeat of the Great Depression than that of another Japan, which, following a stock-market and real-estate mania that peaked in 1989, suffered through a so-called “lost decade” — 10 years of economic stagnation and a seemingly unending cycle of falling asset values and government bailouts…

…contagion is like a flood. It finds its way into the part you don’t protect.” In 1929 and its aftermath, that meant stocks purchased on credit and bank deposits. The protections added in the 1930s were remarkable, and their effect endures. Today, though banks are under pressure, their depositors sleep soundly. People lose jobs but they receive unemployment and continue to spend.

But those protections are hardly enough. Financial innovation ever seeks the freest terrain. The last generation has witnessed a hothouse of new financial products — really a new, more supple notion of finance, and one that is incredibly complex. But the basic securities architecture from the New Deal remains unchanged and has even been loosened.

A generation ago, if you bought an insurance policy against a default, the insurer who sold it was required to maintain adequate capital. Today, you can enter into a credit-default swap (A.I.G. wrote billions of dollars worth) even if your capital is insufficient. Every derivative (thanks to Wall Street’s successful lobbying) was declared to be not a security, and thus largely outside the sight of the Securities and Exchange Commission. Our umpires have been watching the wrong field.

This is not to say that Washington is the main culprit. Markets were incredibly foolish. The dubious mortgages that were written, the credit ratings that blessed them and the trust that banks put in them were speculative and stupid. But we know that people do foolish things. Markets almost demand it. If you are Lehman Brothers and you do not borrow, you do not earn as much as your peers; then your stock falls and you get taken over. So you borrow. Only regulation can check this instinct. Investment banks should be subject to limits on leverage; hedge funds need scrutiny; and more. Alan Blinder, the former Fed vice chairman, says the next president and Congress will have to redraw the entire regulatory map, because “it’s been shown to be wanting.” Amen.

While I definitely believe that we need a new set of regulations (or to “redraw the regulatory map”) , the thing that concerns me is that creating new regulations always seems to be a tug of war between innovation & growth vs. control & safety. When times are good, regulations are relaxed and a lot of risk is introduced into the equation, and when times are bad people overreact and perhaps regulate too strongly.

In my view what’s needed is not so much a new regulatory map but a completely different mindset towards creating regulations in the first place, more specifically creating an environment that allows people to innovate but prevents them from getting into trouble/creating another crisis. In other words, everyone involved should be on the same page: “while we want to foster innovation it’s just not in anyone’s interest to remove regulations that would make it easier to create future economic crises, so let’s always err on the conservative side”.

Of course politicians and the banks agreeing to an approach like this is just wishful thinking on my part, and the likely scenario is a set of knee jerk overly strong regulations that will be gradually phased out as the economy improves.

Unfortunately we all know how that story is likely to end.

You can read more here.

Sources:

The NY Times: “Regulator in Chief” – Roger Lowenstein, September 26, 2008.

Disclosure: at the time of publishing the author didn’t own a position in any of the companies mentioned in this article; the ideas expressed are solely the opinions of the author and shouldn’t be viewed as financial or investment advice.

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