The myth of financial regulation

TODAY’S FINANCIAL MARKETS will inevitably suffer another crash. This could happen soon, especially if recent inflation proves to be more sustainable than the authorities suggest. But even if the markets escape problems for the immediate future, wild swings are an inevitable feature of financial markets. No reasonable regulations can protect themselves from this either, certainly not those that Washington put in place after the last crisis. The regulations are simply inadequate for the task.

The only taming mechanism that could work would tighten regulatory control so much that the United States would lose much of finance‘s contribution to the nation’s prosperity and economic development, a cure worse than evil. Since governors of the past – gold and fiscal discipline, for example – have little practical application today, a better solution, perhaps the only one, would be to keep regulation as a moderator but d ” admit that the objective of control is beyond our reach, that serious risks always remain present. Perhaps such a sense could instill more caution in financial management than it has shown in some time, at least enough to improve boom-bust trends. Such a feeling and the caution it arouses among financial players have sometimes done so in the past.

The REGULATORY approach did little to prevent the 2008-2009 accident. Dodd-Frank regulation did not exist at the time, but several authorities – the Federal Reserve (the Fed), the Comptroller of the Currency, and state regulators in that country; the Bank for International Settlements (BIS) in Basel, Switzerland, internationally, and its counterparts in most other countries, have imposed regulations to guard against financial excesses and collapse. Yet all of their rules failed to stop the previous boom and this terrifying collapse. When investment bank and broker Bear Stearns exposed problems and sparked the crisis in early 2008, the company was in full compliance with all regulations. It was fully solvent according to all the most recent accounting standards. However, he was unable to meet all of his immediate business obligations. Almost to admit that the regulations were inadequate, the authorities tried to control events by immediately turning to outside regulatory structures. They forced Bear Stearns to sell off at a bargain price to JP Morgan – a preemptive move that, in retrospect, may have created more unease among investors than it alleviated.

Although all the major financial institutions had adhered to the regulations in force, the financial crisis worsened before it improved. At each stage of the collapse, the authorities have taken up the challenge of the moment by leaving their own regulatory structures. Ultimately, the Treasury Department put billions of taxpayer dollars at risk, lending to financial institutions through what it called the Troubled Asset Relief Program. The Fed and other central banks have cut lending rates around the world to excessively low levels, near zero in fact, and have found new ways to make billions of financial liquidity available to banks and others. otherwise failing financial institutions. The authorities have forced sales, granted extraordinary loans, taken over financial companies and allowed others to go bankrupt. While this rigged approach didn’t exacerbate the panic, it certainly confirmed the feeling at the time that no one was in control. More than anything else, the extraordinary measures have exposed the inadequacy of regulation.

Following the crisis, Washington undertook to put in place safeguards in large part by doubling the regulatory approach that had just failed. While the details of their new rules are even more complex than the old ones, most of them only reinforce what was there before. The latest set of BIS guidelines, for example, under the heading Basel IV to distinguish them from the old rules of Basel II and III, addresses the problem by stipulating that banks should set aside a total of around 8% of capital. of various kinds. , depending on the risk of their asset mix. This emergency capital is usually held in very safe repositories, government debt or central bank deposits, where the financial institution can draw on it quickly and reliably to meet its obligations when the normal course of business fails. does not. Dodd-Frank financial reform in the United States essentially did the same. It includes two additional noteworthy measures. It distinguishes large institutions whose failure could threaten the financial system, designates them as “too big to fail” and imposes particularly stringent capital requirements on them. It also states that these institutions undergo periodic “stress tests” to see how hard they could withstand financial hardship.

These new, stricter and intrusive rules may provide certain guarantees. They can help regulators – and the public – feel more secure. They can even reassure people involved in finance. Basically, however, they are, like the old rules, chimerical. At least three reasons stand out: 1) Because rules by nature focus on particular financial institutions, vehicles and processes, they cannot cope with the multifaceted capacity of finance to create new institutions and new processes that effectively circumvent regulations; 2) regulations do little to counter the tendency of finance to rely on success and therefore inexorably move in good times to extremes which ultimately create problems; and 3) the capital ratios and stress tests imposed on financial institutions do little to mitigate the inherent risks that banks and other financial institutions must take in the normal course of their business, risks that can easily overwhelm even capital requirements. the most severe required by regulators. The following three sections take up each of these regulatory shortcomings in turn.

FIRST of these problems lies in the inevitably legalistic nature of regulation. Rules should explicitly state to what types of institutions they apply and under what conditions. While such constraints may limit risks in the types of institutions and activities they identify, the constraints themselves only invite the development of new institutions, practices and arrangements not explicitly covered by the rules. Dodd-Frank, for example, limits the level of risk banks can take and the loss allowances they must build at each level of lending risk. But because risky borrowers still want funds and will pay relatively high rates to get them, new institutions and practices have arisen to fill the void left by constrained banks. Since the entry into force of Dodd-Frank, a so-called “shadow banking system” has taken a considerable volume of business from conventional banks, especially small regional banks. She did take the risks that banks once took. Despite the tightening of regulations, the financial system as a whole remains exposed to these risks and remains as vulnerable as it was. All that has happened is that the epicenter of risk has shifted.

Likewise, the regulations put in place after the 2008-09 crisis mainly relate to real estate. The vulnerability of the system at the time centered on defaulting mortgages. Banks are reluctant to expand into this area because regulations impose so many constraints and because bankers are well aware that regulators are watching. Until recently, they were more careful with home loans than even the rules require. But they also want to offer attractive returns to their shareholders. As a result, they have lent more actively than before to risky corporate borrowers who will eagerly pay higher rates to secure the funds. Depending on how you measure them, these leveraged loans have grown by 7-10% per year since the Dodd-Frank regulations came into effect. Today, they are close to $ 3.5 trillion in assets. Because leveraged loans were not the cause of past problems, they are of lesser importance to regulators and are not also covered by written regulations. Again, the risks have simply changed, not gone.

Some could undoubtedly suggest that the system would find better protection if regulators had the freedom to adjust the institutions and practices covered by the rules and to impose similar restrictions on any new practice or potentially threatening financial instrument. If such an approach could provide reassurance about future crises, it would impose other difficulties. In fact, it would shift decisions about the allocation of financial resources from the economy from financial decision makers and markets to regulators. Since regulations by design have a one-sided goal of reducing risk, such a “solution” would limit the financial resources available to start new businesses and expand existing ones. After all, some of the more productive developments over time seemed very risky at first. As a result, society would experience slower rates of growth and job creation. Such regulatory discretion would not count quite as the kind of central planning that failed in the Soviet Union. It would be even worse, since risk aversion would be his only consideration.

NOR CAN regulations effectively stop the tendency of the financial system to go to extremes. This problem grows because past successes in lending, presumably in good economic times, increase the flow of profits to financial companies, with which they can broaden the capital base and, therefore, grant more loans and investments. ‘investments. As these loans further increase profits and probably also increase the value of financial assets, this capital base grows even more, encouraging new loans. The system effectively builds on itself. Indeed, the rise in the base pushes financial managers to lend more and more, and therefore to take more risks. If caution holds them back, they seem to be wasting opportunities for profit and putting their positions at risk. In the words of former Citigroup CEO Charles Prince, “as long as the music is playing, you have to get up and dance”.

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