Why Demand More Regulation?

There have been many demands, especially from the left, for more regulation of the world’s banks after the catastrophe that started last year. In addition to regulation other forms of coercion, from government threats to protest have been used to subvert the banks.

However this seems to be a knee-jerk reaction. I have not seen anywhere a considered argument to show that lack of regulation in the banks was a major factor; many arguments have been advanced for regulatory failure, but due to excessive or incorrect regulation.

Indeed I have seen many mentions of regulations that actually helped to both set up the underlying high-risk mortgages and to pass the crisis through the banking system in the USA. Banks were chastised for ‘racism’ when it was realised that a higher proportion of blacks were turned down for mortgages than other groups in the USA, and threatened with the law. This was backed of course by political action by the left, including ACORN who bullied banks with demonstrations and by Clinton’s administration.

So at least to some of the cause was the regulation itself and non-regulatory coercion by the government, regulators and even campaigning bodies politically connected with many of those currently demanding more regulation and trying to tell the banks how to operate.

The Mercatus Center at George Mason University has published an interesting paper by Arnold Kling detailing some of the regulatory failings that led to the collapse. The main thesis is that regulations intended to deal with previous banking problems from the 1930s to 1980s set up a series of conditions necessary for the recent crisis to occur and to have such widespread effects. In the process it has gained my grudging approval for the initial government financial support for financial institutions in the USA (although I am rather less certain about those in this country, and think that the banks should now be allowed to pay the money back, which Obama has resisted).

However what I found far more interesting is that actually the banks were subverting the regulations then in place with the tacit agreement of the regulators. Those banks were moving risk off balance sheets, and circling risk around the markets and buying back more. So-called NRSROs (agencies approved by the government to rate the risk on credit instruments) had an incentive to play down risks and so upgrade credit ratings, and followed that incentive.

All this meant that by the rules of international banking agreements reached in Basel the banks cut the capital holdings they were required to keep to back their debts from about 8% to about 4.5%. That effectively increased their exposure, their leverage, by over 75%. This was great, because they were making money on these deals, so to increase the amount they could buy into by 75% meant they made 75% more profit.

The articles quoted by Kling written by regulators at the time show that they not only knew about the banks subverting the rules, but approved of it, for the same reason as the banks. The regulators approved because it allowed the banks to do more business, by higher leveraging.

Of course when it all started to fail it was the high leveraging, the low capitalisation and use of over-rated instruments to capitalise that caused the domino effect and a run on the banks and insurance institutions. Had the spirit of the rules been followed then they would have been able to meet immediate obligations, and would not have had to offload poor assets in a great hurry, further suppressing prices and triggering capitalisation problems at other banks whose supposedly safe assets used as capital had just been devalued and who themselves were insufficiently liquid, so had to sell the same poor products that no-one wanted any more and further collapse the price.

So if the regulators are not capable of holding the banks to account, in fact they agree with the banks, all the regulation in the world will simply be circumvented. Huge amounts of money can be made by getting around regulation others follow, so a lot of sharp, innovative people are paid a lot to do so, and regulators’ vigilance must be equally sharp or they are worse than useless.

Now I don’t advocate an unregulated market. However regulation should be as light, simple and intelligently-designed as possible, and then firmly enforced.

In this case capitalisation rules were in place. They were over-complicated and poorly enforced to set up the situation where the crisis could occur. They then became part of the crisis, spreading it from bank to bank as each was forced to sell assets as prices of those assets collapsed, forcing prices further down.

Hat tip to Small Dead Animals for the article and video.

Update: Lisa has provided a link in the comments to an interesting video.

Although it does suggest talk several years ago of more regulation, this only applied to Fannie Mae and Freddie Mac, which as Government-Sponsored Enterprises (GSEs) did not fall under the same rules as independent institutions. However they were subverting the rules that did apply, by buying political influence to attack the regulator when he found the problems.

Note that while I suggested there should have been concern at capital reserves of 4.5% in the commercial banks, Freddie Mac was down at 3% with Franklin Raines claiming this was so secure they should be able to drop to “…under 2%”.

This video is partisan, only showing Democrats defending Freddie Mac and Republicans talking of concerns and of more regulation, whereas some Republicans were taking money from the two GSEs. However the vast majority of money went to Democrats, and there is far more evidence of defence of GSEs malpractices by Democrats many of whom now work closely with Obama. Note that one of he reasons given in the video for defending Fannie and Freddie is that they allowed ‘innovative’ mortgages – exactly what caused the crisis, but important to ACORN and the Democrats.

Update: and evidence suggests it probably wasn't executive bonus culture that caused the crisis either.