Tuesday, February 17, 2009

Regulation Blues

. Tuesday, February 17, 2009

Viral Acharya and Matthew Richardson, professors at NYU, do a postmortem on the American financial industry:

But wasn’t the risk transferred through credit derivatives?
Somewhat surprisingly, this is not the ultimate reason the financial system collapsed. If this were it, then capital markets would have absorbed the losses, and the financial system would have moved forward. Instead, blame needs to be squarely placed at the large, complex financial institutions (LCFIs) -- the universal banks, investment banks, insurance companies, and (in rare cases) even hedge funds – that dominate the financial industry.
The biggest fault lies in the fact that the LCFIs ignored their own business model of securitisation and chose not to transfer the credit risk to other investors.
The whole purpose of securitisation is to lay risks off the economic balance-sheet of financial institutions. But the way securitisation was achieved – especially from 2003 to the second quarter of 2007 – was more for arbitraging regulation than for sharing risks with markets.

(italics added)

This aspect of the financial crisis is under-discussed. The popular narrative says that the crisis was caused by an extreme market failure, spurred on by self-regulation of financial markets and ratings agencies. But as Acharya and Richardson note, much of the "financial innovations" at the heart of the crisis arose because of regulation. In other words, the banking industry (which, in actuality, is heavily regulated) securitized debt as a means of holding more risk than regulations allowed. The actual workings of how this was done gets complicated very quickly, but suffice it to say that banks have on-balance sheets capital requirements which preclude them from directly accruing too much debt (i.e. over-leveraging). To get around the regulations, banks began holding off-balance sheet "special investment vehicles" that basically served the same purpose as holding excess risk, but with far less transparency. The ratings agencies looked at the balance sheets and saw banks that were within the regulatory rules, and with acceptable balance sheets, so they gave them good ratings.

Of course it was a house of cards. Everyone mis-priced the systemic risk that these derivatives created. But the irony is that the actual risk exposure to the banks would have been much more apparent to investors, and thus priced more appropriately, if there were fewer regulations, not more. Acharya and Richardson:

In a world without regulation, creditors of financial institutions (depositors, uninsured bondholders, etc.) would put a stop to excesses of risk and leverage by charging higher costs of funding, but lack of proper pricing of deposit insurance and too-big-to-fail guarantees has distorted incentives in the financial system. And, for years, regulation – capital requirement in particular – has targeted individual bank risk, when the justification for its existence resides primarily in managing systemic risk.

This is something that proponents of stricter regulation much answer to: if the underlying problem is that of regulatory arbitrage, will more regulation provide more security or more opportunity for risky arbitrage? The latter seems as likely as the former. (It is also instructive to note that the less-regulated hedge funds have generally fared much better in this crisis than the more-regulated banks, despite the fact that hedge fund operations are much less transparent.)

Unfortunately, if there are answers to be had we won't be getting them from Acharya and Richardson. Their proposals for the future of the financial regulatory structure are vague ("enforce greater transparency"; "prevent obvious regulatory arbitrage"), and beg the obvious question: if regulators and policymakers did such a poor job of anticipating this financial crisis, why should we have any faith that they'll be able to anticipate (and head off) the next one?


Regulation Blues
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