Monday, July 21, 2008
Markets Police Themselves Poorly, But Regulation Has Its Flaws
The lastest epside of credit crunch indicated that neither market discipline and regulation succeeded. Still in the short term, the pendulum between market force and regulation will swing to more oversight... The events of the past few weeks leave U.S. policy makers at a crossroads in a long-running debate about how to police financial markets. For much of the past quarter-century, policy has tilted away from strict regulation and toward relying on market discipline to keep the financial system on an even keel. Market players, the thinking went, had an incentive not to push themselves or their counterparties too far, because they had too much to lose if they did. This approach has failed, but finding a workable alternative won't be easy. Carmen Reinhart, a University of Maryland economist who has studied centuries of financial crises, concludes that blowups happen almost inevitably after financial markets are liberalized or some innovation allows capital to flow more freely. She and fellow researcher Kenneth Rogoff found that during the loosely regulated 1980s and '90s there were 137 banking crises around the globe, compared with a total of nine during the more tightly regulated '50s, '60s and '70s. Deregulation of interest rates on deposits at U.S. thrifts in the early 1990s, for example, led to a wave of risk-taking and the savings-and-loan crisis. "Market discipline exists in theory, but in practice, ahead of each crisis, what we see is quite the opposite," Ms. Reinhart says. Such discipline clearly broke down at places like Citigroup and Merrill Lynch, which in the past nine months have written down more than $80 billion combined on bad investments. They took too many risks on complex mortgage investments that they created but didn't adequately understand. More broadly, Wall Street's version of market discipline produced the worst housing crisis since the Great Depression -- just a few years after a burst bubble in Internet stocks. Yet in recent days, the alternative to market discipline -- regulation -- hasn't stood up very well to scrutiny either. IndyMac Bank, the mortgage specialist that collapsed earlier this month, was a federally regulated bank. The failure of the IndyMac Bancorp unit could cost American taxpayers as much as $8 billion. Ms. Reinhart likens the hodgepodge of state and federal bank supervisors to a "banana republic" of regulation. Fannie Mae and Freddie Mac, the troubled U.S. mortgage giants, are another example of regulation gone awry. They have their own regulator, the Office of Federal Housing Enterprise Oversight, whose main mission is to ensure they have enough capital. Despite the oversight, they might need capital injections from the U.S. Treasury amid mounting mortgage losses. Unlike other areas of the economy, the Bush administration has been trying for years to sharpen oversight of the two companies. Congress is finally near completion of legislation that would create a stronger regulator to watch over Fannie and Freddie. But that comes too late for the current foreclosure crisis, which has shown that their capital requirements were too low. Ironically, hedge funds -- which are largely unregulated, and where market discipline remains the government's main policy tool -- haven't produced a major blowup this cycle. The Federal Reserve has pushed investment banks to ensure that their hedge-fund clients don't borrow too much and get overextended. So far, it seems to be working. With the exception of two funds run by Bear Stearns, no major hedge-fund players have collapsed during the current credit crunch. However, the hedge funds did play an important role in fueling the credit boom that preceded the current crunch -- by funding and trading many of the complex debt instruments that have quickly unwound. Collateralized debt obligations and credit-default swaps, two kinds of debt instruments that played a starring role in Bear Stearns' troubles, were the playground of many hedge funds. John Paulson, the billionaire hedge-fund manager, made his fortune by using these markets to bet against housing. "The enormous losses and write-downs taken at financial institutions around the world since August, as well as the run on Bear Stearns, show that, in this episode, neither market discipline nor regulatory oversight succeeded," Fed Chairman Ben Bernanke said in a major address on regulation earlier this month. The conclusion is humbling. Policy makers need to fix a broken financial system with policy levers they know are damaged, too. The pendulum between market forces and regulation has no reassuring place to swing, though in the short-run, it is surely swinging toward regulation. Unlike his predecessor, Alan Greenspan, a strong advocate of letting the market discipline itself, Mr. Bernanke has been pushed into the role of Mr. Fixit, forced to strike some new balance with more regulation. That will mean tinkering with everything from the way that credit-derivatives trades are settled to the way investment banks manage their short-term funding in "repo" markets, where they use securities as collateral for short-term loans. It will also mean broadening the Fed's powers to oversee investment banks and possibly others. Some economists, while quick to acknowledge the market's failure, also look upon this shift with trepidation. "What we have is obviously very dynamic markets that have the ability to run circles around regulators and they have an incentive to exploit every possible opening there is for regulatory arbitrage," says Raghuram Rajan, a University of Chicago economist who sounded alarms about the excesses building up in the financial system back in 2005. One of the most important, and least talked about, needs for overhaul, he says, is making sure that bankers have the right incentives: for example, in their own compensation, to ensure they don't push their institutions to extremes. "Regulation can work better if you have the governance issues straightened out," he says. There are other risks in this building shift toward more regulation. As Mr. Bernanke pointed out in his July speech on the subject, the act of bailing out financial institutions like Bear Stearns, Fannie Mae and Freddie Mac could undermine market discipline even more. If a bank's managers know their institution won't be allowed to fail, they have an incentive to take bigger chances. "Market participants might incorrectly view the Fed as a source of unconditional support for financial institutions and markets," Mr. Bernanke said. That's one reason why the Fed and the Treasury seem intent on seeing shareholders of firms like Bear Stearns punished when their institutions need help. Somebody needs to pay, and the board has to answer to shareholders. The other risk is that regulators go too far, coming out with new rules that stifle innovation or risk-taking. In the early 1990s, regulators came to bear the brunt of blame for the credit crunch because of the demands they placed on banks and thrifts to tighten their standards and build capital. The regulators are cracking down again now, two or three years too late.