Monday, July 6, 2009

Ever Wonder Why Regulations Don't Work?

Proposals don't fix reason for crisis

Politicians, like generals, fight the last war. A clear case in point is the proposed legislation on financial institutions.

The main parts are that the FDIC would be able to seize nonbank companies that pose a systemic risk to the economy, the Office of Thrift Supervision will be merged into the Office of the Comptroller of the Currency, financial companies would be required to hold more capital, hedge funds would get regulatory oversight, a new consumer agency would be created to regulate financial products, and the Fed would get oversight authority over all big financial companies.

These proposals are backward-looking. The power to seize nonbanks was likely prompted by the failure and subsequent bailout of AIG. The imposition of more capital would lessen the cost of failure to the government but not lower the likelihood of failure. The government has always wanted to regulate hedge funds, and the financial crisis gives it that opportunity, even though hedge funds had nothing to do with the financial crisis. There were critics of some financial products offered to consumers, but the banking agencies already had oversight responsibilities, making the new agency redundant. Since the Fed already regulates bank holding companies and financial holding companies, the new legislation must intend to include financial institutions that are not members of holding companies.

The merger of the OTS into the OCC is of little consequence.

Note that none of the proposals addresses the reasons for the financial crisis - namely asset bubbles. Remember when Alan Greenspan said in 1996 referring to the stock market that "irrational exuberance has duly escalated asset values?" That bubble was fueled by the dot-com craze and wiped out more than $5 trillion in market value. Although the rules will do nothing to prevent asset bubbles, at least they also will do little harm - which is in direct contrast to cap-and-trade, which arguably is the single worse piece of congressional legislation in the history of the republic.

What to do? Here is some unsolicited advice from someone who has taught regulation, written regulation, headed a federal regulatory agency, and been the subject of regulation as a director of one of the nation's largest savings and loans and as a director of the nation's largest real estate investment trust:

n There is no such thing as systemic risk. If it is too large to fail, it is too large to exist. Use the existing anti-trust legislation to limit monopolies (private or government) and to encourage competition.

n The market is always ahead of regulation. Enact rules that make market participants apply for use of new instruments and explain their risk. The regulator would have 90 days to either approve or disapprove. If no action is taken, then the instrument can be used.

n Prevent asset bubbles. Both the New York Stock Exchange and Nasdaq can suspend trading of company stocks and that of the entire exchange. The SEC also can suspend trading if it "is in the public interest."

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