Thursday, February 18, 2010

Can regulators who failed be trusted to regulate again to prevent failure?

Or has perdition frozen over!

Excerpts: The Naive Conceit of Banking Regulations By John Tamny

Past troubles within the U.S. financial system continue to generate a great deal of feverish commentary from allegedly wise minds in the economic commentariat about how to fix what was broken. The general view is that something must be done in terms of legislation and regulation to ensure that another banking crisis of the kind which occurred in 2008 never happens again. . .

Unfortunately for both sides, the calls for more regulation will not work for ignoring greater realities about talent, incentives, and the certain truth that failure of any kind is an essential economic input, along with a clean form of regulation itself.

Implicit in the argument for more or better financial regulation is the naïve assumption that the kind of person willing to work for the government has the skills necessary to regulate a financial sector which, by virtue of the profits historically achieved in the space, attracts some of the greatest minds in the world. More realistically, it should be said that the individuals who populate the Fed, SEC and Treasury in many instances couldn't get jobs in banking, which points to a certain talent deficit when it comes to overseeing the activities of those that could.

Some might point out that many regulation functionaries are in possession of talent, but view government experience as a way of gaining skills that will make them even more valuable to Wall Street in the future. No doubt that's true to an extent, but their private-sector designs make them even more unworthy of the regulation they're entrusted with. . .

When we consider incentives, in the private sector managers are rewarded for doing more with less, and generally for figuring out how to destroy jobs. Within government, however, the opposite is the case. If government employees do their jobs too well, then they essentially put themselves out of work.

Looked at in light of financial regulation, ever since the crisis the Fed, SEC and Treasury have asked for and received more money and resources to root out financial malfeasance. To put it very simply, the regulatory bodies charged with overseeing finance labor under perverse incentives whereby their failures are rewarded.

Most glaring about the conceit of regulatory policy is the certainty that we're asking regulators to do the impossible, as in see in the present what will be problematic in the future. In that sense, when politicians and commentators complain about regulatory failure, they're in truth paying those who supposedly failed the highest of compliments whereby they ascribe to the prosaic government bureaucrat a level of intelligence that logic tells us is non-existent.

If regulators were actually in possession of the kind of otherworldly skills allowing them to see into the future, they most definitely would not be working for the government. Instead, they'd be making billions in the private sector. . .

there is no "third way" when it comes to failure. Implicit in their proposals is the utopian notion that failure can be simplified.

Instead, it's very necessary that the externalities of bank failure be felt acutely by all investors and counterparties so that the same mistakes aren't made again.

So that we can avoid a repeat of the horrors felt in the markets when the federal government used money taken from the private sector to save institutions that the private sector rejected, it's essential to simplify, rather than confuse or expand regulation of finance. Basically we need to reduce the presumption of financial regulation to twenty-three words: financial institutions that can't access private funding in order to continue their operations will be allowed to go bankrupt free of government interference.

Only then will self-interested investors enforce the kind of barriers to extreme risk taking that had most of the financial sector near death less than two years ago. Indeed, if made aware that failures will be their own, banks, investors in same, and counterparties will surely amend their activities with this new "freedom to fail" in mind.

If not, if we're truly gullible enough to believe that the very regulatory conceit that has failed so impressively for so long should be given another chance to succeed, we'll only have ourselves to blame when the next financial crisis reveals itself. It will most definitely be the result of false hope wrought by naïve arrogance suggesting under-qualified bureaucrats, as opposed to self-interested investors, know best how to protect what is theirs.

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