Reducing systemic financial risk

I temporarily found myself in the unfamiliar position of agreeing with Paul Krugman — in fact, twice in one week. First, I quoted favorably Krugman’s quote about the curse of the Business Week cover. (This observation seems derivative of the famous Sports Illustrated cover jinx, but still an incremental contribution).

On Friday, Krugman’s NYT column was entitled “Making Banking Boring,” which harkens back to the old days when our banking system was based on providing low-risk, low-reward financial infrastructure. It was a plausible argument.

Digging further, however, and the assumption starts to fall apart: the record does not support the assumption that reverting to the high regulation of 65 years ago will solve all the problems. As Theodore Bromund of Heritage wrote (in response to the G-20 communiqué)

Much of this language ignores one of the basic facts about the financial crisis: it was the regulated banks that failed, and governments are now trying to clean up the mess by encouraging less-regulated investors in hedge funds to step in.

If regulation and oversight were the cure-all for the development of systemic risk the summit implies, the financial crisis would never have happened.

Certainly Krugman would not agree with AEI regulatory expert Peter J. Wallison, who contends that higher government regulation will increase risk-taking by creating more Fannie Maes.

In his Congressional testimony last month, Wallison testified against a plan that would heavily regulate any “systemically significant firm” (i.e. too big to fail):

Giving a government agency the power to designate companies as systemically significant and to regulate their capital and activities is a very troubling idea. …

I say this as a person who has spent ten years studying, writing about, and warning that Fannie Mae and Freddie Mac would have a disastrous impact on the financial world, and that ultimately the taxpayers of this country would be required to bail them out.

This wasn't a wild guess on my part. Because they were seen as backed by the government, Fannie and Freddie were relieved of market discipline and able to take risks that other companies could not take. For the same reason, they also had access to lower cost financing than any of their competitors.
…
When Fannie Mae and Freddie Mac were taken over by the government, they held or had guaranteed $1.6 trillion of subprime and Alt-A mortgages. These loans are defaulting at unprecedented rates, and I believe will ultimately cost U.S. taxpayers $400 billion. That's major league risk-taking.

There is very little difference between a company that has been designated as systemically significant and a GSE like Fannie or Freddie. Almost by definition, a systemically significant firm will not be allowed to fail--because its failure could have systemic effects. As a result, it will seem less risky for creditors and counterparties and will thus be able to borrow money at lower rates than its competitors. This advantage--as we saw with Fannie and Freddie--will allow it to dominate any market it chooses to enter. …

Regulation does not prevent risk-taking or loss. Witness the banking industry, the most heavily regulated sector in our economy. Many banks have become insolvent, and many others have been or will be rescued with billions of taxpayer dollars.

On the other hand, as far as I am aware, no taxpayer dollars have been spent to rescue hedge funds, although they are entirely unregulated for safety and soundness.

Extending regulation beyond banking, by picking certain firms and calling them systemically significant, would be a monumental mistake. We will simply be creating an unlimited number of Fannies and Freddies that will haunt our economy in the future.

Wallison concluded

We will achieve nothing by setting up a systemic regulator. If we do it at the cost of destroying faith in the dollar and competition in the financial market, we will have done untold harm to the American economy.

As Wallison does, I believe that market discipline (especially consequences for failure) are necessary to reign in excesses by firms. We should deal with the problem of “too big to fail” by making failure less catastrophic for the financial market, not attempting to legislate away the consequences of inevitable human error.

At the same time, financial firms also need better incentives internal governance, so that a CEO that wrecks a company (whether Lehman Brothers, Bear Stearns or Fannie Mae) pays the same price (or greater) that shareholders and employees pay for such failure. One would hope that market forces — notably the institutional investors that lost 30-90% of their money in 2008 — would have an incentive for making this fix, but so far there isn’t much progress.