Tuesday, July 13, 2010

FinReg

. Tuesday, July 13, 2010

Up till now, I've refrained from commenting on the financial regulation bill that now looks set to become law for two reasons. First, it wasn't clear exactly what would be in the bill. Second, it wasn't clear whether anything would pass. Now that we have pretty clear expectations about both of those things, I'll share a few thoughts.

This bill is not designed to prevent the next financial crisis from occurring. In fact, it would not have prevented the last crisis. This is a very good thing. Too often, regulatory policy is shaped as if by "generals fighting the last war," i.e. regulatory policy is designed to protect against the last event rather than improving the overall ability of the system to withstand disruptions. This approach is self-defeating, since financial crises seldom have the same proximate causes, so this approach will never get it right.

So is this bill good? I think so. To understand why, consider this:

If there's any problem it solves, it's the regulatory confusion and weakness we saw amidst the last financial crisis. That's different than the regulatory confusion and weakness that allowed the last financial crisis to happen, of course.

The bill does that in two ways: The first is providing regulators with a lot more information. By placing derivatives on exchanges and clearinghouses, by creating a systemic risk council, by forcing banks to provide "funeral plans" that explain how to unwind them in the event of a failure, by creating an Office of Financial Research to collect daily data and provide quick analysis on transactions, there's much less chance that a financial crisis would leave regulators totally confused about what's going on, and who owes what to whom.

The second way is by providing regulators with more power to oversee all financially important institutions, rather than just banks, and giving them clear legal authority and a predictable method for executing a failing institution. That's the resolution authority you're always hearing about, and though the number of sign-offs it requires before it can be used (Fed, Treasury, FDIC, and three bankruptcy judges) seems so onerous that it'll make early implementation impossible, once everyone agrees that a firm needs to be brought down, it'll be much easier to do.


In other words, this bill presupposes that financial disruptions will occur in the future and makes preparations for dealing with them. The focus is on increasing transparency, preparedness, and planning for winding down insolvent firms. It doesn't do much on liquidity or capital adequacy requirements, which are the focus of the international negotiations of the Basel Committee. (I'll have more to say on that soon.)

A few weeks ago Tyler Cowen ran through the major provisions and offered commentary. The mantra was "the devil is in the details", and they most certainly are. How much transparency we get and how robust the resolution authority is matters quite a lot, and it is probably impossible to fully know in advance how these things will work. Cowen's conclusion:

The bottom line: the good parts of the bill aren't nearly as good as they should be, and the bad parts became much better with time. The biggest omissions are simple and tougher restrictions on leverage and reform of the mortgage agencies. Overall consider this a victory for the status quo and you should realize that the underlying problems have not been solved.


I'm more optimistic than Cowen. I don't think the "underlying problems" can be solved solved so easily. Trying hard to do so may invoke the Peltzman Effect, which (arguably) played a major role in this crisis. Remember that many derivatives were created to avoid regulation; the resulting opacity was a major contributor to the crisis. Is anyone sure that we can close all loopholes or anticipate all possible weaknesses in the future? If you want a less complicated, more open financial system, then the solution is likely not to create ever-more-complicated regulations that incentivize the exploitation of loopholes. The solution is reduce opacity, strengthen overall stability, and be prepared for adverse scenarios. I think this bill makes some progress on those fronts.

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