Regulating Risk Is Risky Business

“Certainly do not give a systemic regulator the job of determining when the next financial crisis will hit,”  Alan Greenspan said in a speech at the American Enterprise Institute. The federal government does not appear to think the former Fed chief has any idea what he is talking about.

Several news services have reported that the Administration will announce its new plan to regulate financial markets as soon as mid-month.

The programs being suggested by the Treasury would give the Fed the job of of monitoring risk in the credit and financial system and the FDIC the power to restructure large financial firms that get into trouble that the free markets may not be able to fix. The FDIC, by extension, would be allowed to judge the efficiency of the markets to handle their own problems.

The new structure of the financial regulatory system is based on the misapprehension that more regulation equals less future risk. There is certainly no sign the government was able to warn banks about their investments in Latin American debt which almost brought down Citibank in 1982 or the S&L trouble that claimed 745 savings institutions in the late 1980s and early 1990s. Each incident brought more regulation, and there is no sign that the addition of government risk management agencies and policies helped to predict or prevent the global credit crisis that began two years ago.

The notion that more regulation means less risk is based on the simple premise that more analysis means better forecasting. The global financial and credit markets are so complex and the effects of changes in the value of private debt and sovereign debt happen so quickly and frequently that keeping tabs on them and getting out in front of problems is nearly impossible.

The first job of new regulators will be to make certain that financial firms do not become over-leveraged again. This will mitigate the risk of creating derivatives instruments that allow banks and hedge funds to gamble a large portion of their assets without a huge up-front investment. The prevention of excessive leverage will not help predict or prevent the failure of pools of loans like commercial real estate which appears to be the next significant challenge that money center and regional banks face.

Government authority is also unlikely to insist that current lending to consumers should be done with less risk and more care than it is today. Banks may have overextended their exposure to consumer credit and may be paying the price with write-offs. But, what is an appropriate exposure when banks are putting capital in the hands of consumers? Banks will actually have to increase lending to people who want to buy homes or begin to buy cars and other relatively expensive goods and services. The evidence at this point is that banks are “under-lending” to consumers and small businesses, threatening a recovery of national GDP. Regulators who want to restrict lending with moderate risk take on the authority of measuring how much capital should go from private financial institutions into the market of the transactions that feed the economy.

The other significant assumption behind the power of regulating the financial markets is that transactions based outside the US can be moderated by the American government. There are a number of risks involved in transactions with sovereign governments and overseas private businesses. Banks that are counterparties to American international financial firms may assume risks outside the parameters set by a new network of US regulation. A systematic failure of the banking industry could begin outside American borders, but American financial institutions could clearly be hurt badly, with or without government oversight.

The proposal that the Treasury will put before Congress assumes that cobbling together several regulatory agencies to create a small and more powerful set of overseers will somehow make the government’s ability to foresee future events better than it is now. There is no historical precedent to indicate that this is true.

Douglas A. McIntyre