The Impact of Banking Regulation on the Market

Reducing regulation is supposed to spur innovation, create more secure markets, etc., by getting the government out of the way and allowing business and "the market" to decide how best allocate capital. However based on the current economic crisis and a study of recent history, it appears that the opposite is true:

 

(From the WSJ): 

The events of the past few weeks leave U.S. policy makers at a crossroads in a long-running debate about how to police financial markets.

 

For much of the past quarter-century, policy has tilted away from strict regulation and toward relying on market discipline to keep the financial system on an even keel. Market players, the thinking went, had an incentive not to push themselves or their counterparties too far, because they had too much to lose if they did.

 

This approach has failed, but finding a workable alternative won't be easy.

 

Carmen Reinhart, a University of Maryland economist who has studied centuries of financial crises, concludes that blowups happen almost inevitably after financial markets are liberalized or some innovation allows capital to flow more freely.

 

She and fellow researcher Kenneth Rogoff found that during the loosely regulated 1980s and '90s there were 137 banking crises around the globe, compared with a total of nine during the more tightly regulated '50s, '60s and '70s. Deregulation of interest rates on deposits at U.S. thrifts in the early 1990s, for example, led to a wave of risk-taking and the savings-and-loan crisis.

 

"Market discipline exists in theory, but in practice, ahead of each crisis, what we see is quite the opposite," Ms. Reinhart says." 

Graphic Courtesy of the WSJ.

 

While I don’t dispute that the era of reduced regulation appears to have led to an increase in the banking crisis, it is worth nothing that the global system is larger, more complex and more interconnected than it has been in the past. So, even if lighter regulation is the root cause behind the increased number of crises, size, interconnectivity and complexity are very likely key factors as well. It’s easier for a bank to get into trouble if it’s delving into complex and often esoteric financial instruments than if it’s just taking deposits and originating loans. Still, a lot of the complexities are the result of deregulation, so it almost becomes a chicken and the egg type of argument.

 

The problem here seems to be that the goal of the markets is to generate profits (often in the short-term), while the goal of a regulator (a good one anyway ) is to ensure that the banking system remains stable. The problem with self-policing is that it assumes that these two goals are always synergistic with one another, that the banks/markets always behave rationally and are always focused on long-term profits over short-term ones. The other issue is that an individual bank will be primarily focused on itself as opposed to the health of the banking sector/the markets overall, so it’s slightly unrealistic to expect a group of self-centered actors to police the whole.

 

Of course it also goes without saying that regulators can be just as fallible for a wide variety of reasons such as relating to staffing levels, having weak abilities to make changes and/or not being able to really respond to innovation until after its already in the marketplace.

 

All that being said, I'm not exactly a proponent of heavy regulation either, because it does stifle innovation and most certainly gets in the way. I think the key is a moderate level of innovation that provides common sense guidelines to keep banks from shooting themselves in the foot. This, as opposed to strict guidelines that make it difficult for the banks to operate. For example tell the banks that they can originate all of the exotic mortgages they'd like, they just need to have documented evidence that the person can afford the highest possible payment over the next 10-15 years using no more than 28-33% of their gross monthly income.

 

While it's a complex problem I think it can be solved if regulators think in terms of speed limits and/or parameters that keep the banks out of trouble, as opposed to imposing heavy regulations or letting the markets police themselves.

 

You can read the article in full here .

 

Sources:

 

The Wall St. Journal: "Markets Police Themselves Poorly, But Regulation Has Its Flaws" -- Jon Hilsenrath, July 21, 2008.

 

Comments

[Jim A]

Markum
Get a grip! The gurus on Wall Street and at CountryWide were lending to people who couldn't even make the first payment and calling these loans AAA rated securities.

[xsuddensam]

Jim A:

Get a grip is right! The WSJ is just making feable excuses and it is towing the industry line with this kind of thinking.

FRAUD is the operative word not "complexity"... These shabby packaged securities were intentionally made complex to hide the weakness of the underlying securities and to mislead investors.

The WSJ needs to lead an outcry of rage against those who have created this awful mess that has hurt millions of investors.

These criminals should be hunted down, brought to justice and jailed. Their assets should be forefeited. Congress should pass stringent laws to harshly punish those who violate the public trust. Just like crimes against humanity, there should be a special class of laws to protect the PUBLIC GOOD.

The WSJ and the foolish stock market touters like Cramer, Ludlow and the rest of the CNBC crew, as well as those on Bloomberg, should be at the forefront of this crises demanding accountability. Where is their outrage?