Wednesday, June 10, 2009

Regulation and the financial crisis

Various people have argued that the current crisis has been the result of a lock of regulatory oversight, that basically allowed banks to do silly things. I fail to be convinced about this argument for the simple fact that the only financial entities that have run into trouble were regulated ones, and the unregulated hedge funds, while obviously facing losses, are still in business without outside help. But it is still worthwhile thinking whether regulation is at an optimal level.

Joshua Aizenman provides a rather intuitive model of banking regulation: regulation reduces the risk of a crisis, but the perceived lower risk reduces support for regulation. Thus, one would always have under-regulation and even no regulation after sufficiently long, crisis free spell. This under-regulation is exacerbated by the fact that the public typically does not observe (or understand) the regulator's efforts. Of course, there is over-regulation immediately following a crisis, especially if it is very costly. Bayesian updating will do that to you. How to prevent these issues? Essentially the same way one prevents the inflation bias of a central bank: independence, transparency and predefined goals.

That said, and I mentioned it above, under-regulation may not necessarily be the trigger of the current crisis. What is sure, however, is that additional regulation is certainly not necessary now. All the activities that people have decried (under-priced sub-prime lending, over-leveraging, etc.) have disappeared without regulatory intervention. Such is the market...

4 comments:

Earthquake Economist said...

Reaction to your statement: "What is sure, however, is that additional regulation is certainly not necessary now. All the activities that people have decried (under-priced sub-prime lending, over-leveraging, etc.) have disappeared without regulatory intervention. Such is the market..."

The above statement sounds to me as arguing after an earthquake that destroyed under-designed real estates that there is no need to regulate more stringently future real estates, as the earthquake already took place…
Regulation should be forward looking, the fact that the financial crisis destroyed AIG does not imply that there is no room to regulate more stringently future AIGs…

from Earthquake Economist

Economic Logician said...

But there is no need to regulate now. Rather, one should think seriously what and how to regulate, and take time doing that, rather than precipitously regulate and do more harm than good. The houses that survived an earthquake are sound.

Milton Recht said...

To Earthquake Economist:

"The above statement sounds to me as arguing after an earthquake that destroyed under-designed real estates that there is no need to regulate more stringently future real estates, as the earthquake already took place…"

Actually, that is a very good point. Future real estate investors will want earthquake-protected buildings constructed to protect their investments even without regulations.

Tenants who value earthquake protection would lease and rent in those buildings. Those that do not value that protection as highly will rent in unprotected buildings. Equilibrium will be reached.

Forcing earthquake regulations on new construction is unnecessary, as it will occur naturally. If old buildings must also comply, some low rent tenants will be forced out because of the higher costs passed through in rent increases. If rents are controlled, the new costs will cut into the buildings' other needed investments and will be postponed indefinitely, leading to deteriorating building conditions.

If there is excess demand for earthquake-protected buildings, property owners will, without regulations, convert old buildings and charge higher rents for the protection.

Regulations will impose rigidity into the system and inhibit the use of new earthquake building technologies as they are developed. Regulations will also add bureaucratic costs and further increase rents, forcing many marginal renters out.

Jamaal said...

I must argue with that logic. A big portion of this crisis has had to do with underregulation and regulator duplicity with malefactors. For instance, the total lack of oversight over derivatives due to awful regulation allowed the mass, dangerous speculation and financial alchemy that made value-less financial products the norm. You can argue that no one now would be stupid enough to buy those because people have burned and those who overexposed themselves have exited the market. But that ignores the fact that this is not the first time that we have seen a credit crisis due to an abundance of exotic financial instruments with insufficient oversight. Or even look at banking rules. We allowed investment and commercial banks to merge, we did not specify tighter caital rules so these new megabanks became overleveraged and we did not choose to examine either the loans or the instruments that derived from the bad loans these banks made in the first place. This was a systemic crisis brought on by poor judgement, over leveraging, and a lack of proper oversight and regulation. The financial sector has repeatedly show its creativity and irrationality. People will invent new ways to make money. It is up to regulation to inoculate the greater economy from unnecessary risk taking. I say we should have considered, well thought out regulation but I cannot in good conscience agree we don't need any because those who risked too much failed.