Remaking Financial Regulation One Brick At A Time

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The Administration is about to release its new plans and programs to regulate financial firms and the trading markets so the the catastrophe of 2008 can never happen again. The core of the policies is to cut and track risk wherever and whenever it can be ferreted out and killed before it spreads across the global banking system and underground trading market for derivatives and credit swaps.

The Wall Street Journal reports that “President Barack Obama is expected Wednesday to propose the most sweeping reorganization of financial-market supervision since the 1930s.” It is not at all clear that the rules and regulation of  the Great Depression era did anything to improve the financial system. Separating banks and brokerages may have undercut the ability of financiers to blend money that should be safe with money that should shoulder risk. The FDIC may have helped depositors whose savings where at risk due to bank closings.

What regulation failed to due was prevent financial institutions from doing what they are meant to do which is make money. The observation may seem facetious, but the ability to create new capital is based on the ability to take intelligent risk. The one thing no set of rules can do is undercut stupidity and eliminate greed. Both seep back into the system like water through cracks in a wall.

The Latin American credit crisis and S&L debacle both happened during a period that middle aged financial executives can remember. Many worked on Wall St. during the periods of those “accidents”. Government regulations in place during those missteps did not do anything to prevent them. New legislation and new institutions were formed to prevent similar problems in the future, but these creations were based on looking back at problems more than predicting what the challenges of the future would be.

The trouble with regulating risk and regulating ill-advised behavior is that it is always created by an analysis of what has happened because predicting what will happen is nearly impossible. Credit default swaps and mortgage-backed securities looked safe enough. Credit ratings agencies helped to get them spread onto the balance sheets of almost every large bank and brokerage firm  in the US and Europe. Risk was not a major consideration because the system said there was none. Risk detection is difficult because risk creation is fast, insidious, and ingenious.

The financial system will not curtail its efforts to find ways to make outsized profits for itself or its customers. The moment those efforts disappear, the reasons for the industry to exist disappear with it. Regulation may try to save the sector by putting it in a box, but there is no evidence that it works.

Douglas A. McIntyre