Think Twice Finance

The Coming Financial Lockdown

Time to talk about what the Feds are going to do about this crisis. The New York Times, that reliable barometer of what the liberal elite would like to do, has opined. No reason, then, for each of us not to put in our two cents. That’s the joy of the internet.

First a little gloating. Waaay back in September 2007, I pretty much knew that the regulatory changes were on the way and I knew why. I can gloat because I wrote it down. Unfortunately, I wrote it down in a boring scholarly tome (“The Definition of Bank and the Subprime Mortgage Crisis: Tying Bank Regulation to Banks’ Risk-Return Trade-offs in the 21st Century.” to be found on Social Science Research Network) but I got my guess written down nonetheless. My thoughts are much different from those of the Times. One thing that pleases me about that article is it included an implicit forecast of which institutions would do well and which poorly in the future that has held up pretty well in the crisis (so far….) But what pleases me most is that the article concludes that the banks that obeyed the Times’ rules-based regulations most slavishly were those driven to it by a lack of creativity and that they would do poorly in the future. These banks have indeed proven most adversely affected by the crisis.

So what will the Feds actually do? There is one action to be taken and a decision to be made. The action to be taken – and this is already a done deal, locked in when the banks started buying up money market mutual funds, leaving the Federal Reserve to preserve the value of these funds as well as the value of deposits – is that the jurisdiction of the Fed will now extend to the investment banks, hedge funds, mortgage brokers, etc. – in short all firms with predominantly financial assets. The investment banks won’t be happy, the private equity funds will be livid, but since the Fed started dealing directly in investment banking assets, investment bankers haven’t a leg to stand on. In fact, there has been little other than monkey business to justify the distinction between regulated banks and unregulated investment banks since the Fed “helped resolve” the Long Term Credit Debacle.

The interesting matter is not this coming change in the definition of “bank.” It is the regulatory decision to be made. Will it be Rules-based-Regulation, or Regulation Lite? How will the Fed control the banks? I have a firm position on this matter. Rules based regulation of the sort that will be favored by the Times, the Democratic majority of Congress, and the probable incoming administration; will guarantee an unprofitable financial system analogous to the collective current feckless collection of large New York commercial banks. Later, when profits flag, regulatory loopholes will be designed as before to shore up the system, loopholes akin to the ones put in place in the last decade. Finally, there will be another crisis that may turn the present one into a fond memory by comparison, some ten years or so from now.

The alternative is Regulation Lite. Regulation Lite focuses on communication between the executives and officials within the system, rather than the rules that have been laid down. The Times won’t like it because it feels clubby, a little too “our crowd.” But its important redeeming feature is that it places responsibility for lack of prudence and malfeasance upon individuals rather than institutions, permitting the regulators to enforce penalties based on a weaker standard of evidence, what they “know” went wrong, rather than what they can “prove” went wrong. An important part of this system is a continuous system of “secondment” of financial market participants into regulatory posts. This has two beneficial effects. The first is awareness among market participants that the executive they are cutting a deal with today may be an official supervising those deals tomorrow. The second is the prevention of bureaucratic naïveté that is the inevitable result of regulation by civil servants only.

Neither system is perfect. But the second preserves what the first destroys: the financial incentive to innovate. The public is right to demand that it be easier to understand the features of the investments and loans that are offered to average individuals, municipalities and the like. This is perhaps the most prominent failure of the financial system in meeting its implicit bond with the public in this crisis.

But this can be achieved without ignoring the fundamental fact of finance. What financiers do for a living is buy money cheaply and sell it expensively. Money is, of course, the ultimate commodity. If the process by which financiers change the cheap money to expensive money is exposed to public scrutiny, trade secrets are destroyed and with them, the profitability of the banks. And Rules-Based-Regulation will inevitably force the disclosure of these secrets or will create the semi-disclosed yet inscrutable dirty little deals between regulator and regulated, attempting to prop up a profitless system, that brought us to the current sorry state of affairs.