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Regulation Usually Fails

Wednesday, February 11, 2009

President Obama should rethink his approach to financial market reform.

President Barack Obama has declared that increasing financial regulation will be a priority for his administration, claiming that insufficient regulation caused the ongoing financial mess. But neither Obama nor his many advisers have proved this connection. There’s a reason for that—it doesn’t exist. The Bernard Madoff scandal is merely the latest evidence that regulation does not necessarily prevent fraud or protect the public. The SEC’s failure to stop Madoff from ripping off his investors and squandering billions of dollars was not an aberration; unfortunately, such regulatory failures are the norm.

The Federal Reserve has traditionally followed a policy of acting to prevent bank collapses, especially collapses by large banks. In 1991, Congress recognized that this policy was hurting the Federal Deposit Insurance Corporation, and it passed the Federal Deposit Insurance Corporation Improvement Act, which was intended to stop the Fed from lending to insolvent banks as their losses increased. During the Latin American debt crisis of the 1980s, the Fed worked with the IMF to avoid recognizing the losses to New York banks. It did nothing to end the crisis. The Fed and the Treasury prevented Continental Illinois Bank from failing, and the Fed did the same for Long-Term Capital Management. These are but a few examples of a longstanding policy. That policy has continued during the present crisis.

At the annual Kansas City Federal Reserve Bank conference in August 2003, Alan Greenspan explained that the Fed could not prevent speculative bubbles. Its task was to clean up afterward. Minneapolis Fed chief Gary Stern urged a change in policy that would discourage excessive risk-taking. But that was not the message that bankers and the credit markets received. They interpreted regulatory policy as a “Greenspan put.” They believed that if they took on more risk, the Fed would keep them from failing.

It was not an absence of regulation, but rather improper regulation that played a major role in fueling the current crisis.

The Fed may not have intended to offer a put, but the market knew it had a long history of preventing failures. Exacerbating this problem was the absence of a clear lender-of-last-resort policy. Banks had to judge what might happen by looking at the Fed’s record, which encouraged them to think that failure was unlikely if they increased leverage to increase profits. The SEC permitted investment banks to increase their leverage ratios to more than 30 percent.

The Fed and the Treasury have responded to recent bank failures by heightening uncertainty at an uncertain time. The Fed forced the acquisition of Bear Stearns, but then allowed Lehman Brothers to fail. Nobody could guess what it would do next. Instead of calming fears on Wall Street, the Fed’s inconsistent actions have greatly increased them.

It was not an absence of regulation, but rather improper regulation that played a major role in fueling the current crisis. Fed officials and administrators don’t want to believe that capitalism without failure is like religion without sin—but it is. It simply doesn’t work, and no amount of increased supervision or regulation will make it work. That is an unpleasant lesson of the current crisis.

It’s not the only regulatory lesson. In my forthcoming book, Volume 2 of A History of the Federal Reserve, I found that most regulators ignore the incentives they foster. I wrote that the first law of regulation is: Lawyers and bureaucrats write regulations. Markets learn to circumvent the costly ones. The Basel Accords tried to promote safety by requiring banks to hold more reserves if they acquired more risky assets. This ignored incentives. The banks followed the first law of regulation. They put the risky assets in structured investment portfolios that were not on their balance sheets. We went from having a system that was not well monitored to having one that was not monitored at all. The world and the regulators learned where the risks went when the holders were about to fail. Bad regulation, not the absence of regulation, made the problem worse.

Unwise regulation will produce more Basel debacles. We need a clear lender-of-last-resort policy, one that governments and central banks are willing to enforce. That can be done. Great Britain successfully operated such a policy for almost 100 years. Banks and financial firms have to change their compensation systems to separate bonuses from short-term results. Regulation cannot do that; it’s a job for corporate managers. And companies that rate risks must have the incentive to return to the quiet life that they followed when they mainly rated corporate and municipal debt. Those who package and sell securities should accept responsibility for what they buy and sell. Sure, the rating agencies did a terrible job, but shouldn’t the high-paid Wall Street firms do some due diligence in return for their hefty fees?

Closing Fannie Mae and Freddie Mac would be a major step toward a better policy. If Congress chooses to subsidize housing, it should do it on the budget. Similarly, all subsidies should be put on the budget and voted on like other federal spending.

Most important of all, fear of failure must be in the mind of every banker and financial manager, every day. If banks are “too big to fail,” the government should force them to become smaller. Institutions that lend long and borrow short will face failure whenever large, persistent changes occur in their environment. That risk cannot be avoided, but it will be handled more prudently if managers recognize that it is always present. Equating social and private costs in this way will do a far better job for all of us than the best-intentioned regulation.

President Obama should rethink his approach to financial regulation. Markets work best when rules induce incentives that equate private and social costs, not when government regulators impose their judgments.

Allan H. Meltzer is the University Professor of Political Economy at Carnegie Mellon University, a visiting scholar at the American Enterprise Institute, and the author of A History of the Federal Reserve.

Image by Getty.

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