Now Showing: Government vs. Free Market (Part 2)
As the financial crisis reverberates thru the world economy, redrawing the lines between government and free markets, here are some objective principles that define the role regulators should play in the new world financial order.
The extent of regulation in general, and financial regulation in particular, plays a large role in defining the business landscape. In addition to determining the broad business environment in an economy, it has several micro, firm-level implications in areas such as governance, risk management and the use of Information Technology. In the first part of this essay we asked the question, How much financial regulation is "just right"? Or, where do we draw the line between government and free markets?This admittedly difficult question has taxed the finest financial brains over the years, and we must clearly not expect any easy answers. People will approach it differently depending on their personal predilections, ideology, historical experience with regulation, current economic conditions and so forth. However, I believe it is possible to lay down a few principles that should help provide an objective basis for arriving at the "right" level of regulation, or at least to evaluate a regulatory regime once it has been devised. Here they are.
We begin with two preliminaries. The first is an admonition from C. A. E. Goodhart, eminent economist and former member of the Bank of England's Monetary Policy Committee:
"Occasional regulatory lapses and failures must be regarded as the necessary cost of devising an effective system of regulation. The degree of regulatory intensity that removes all possibility of failure would almost certainly be excessive.." (Financial Regulation, published in association with the Bank of England, 1998, p. 14).
The second preliminary needs a brief digression to understand the concept of “levees” in business. Uncovered by our research into business model de-risking and innovation, this is a concept that finds application in multiple industries. In business, there are often abstract barricades that inhibit the free play of market forces, or hold legitimate competitive pressures from being transmitted to a company. These are the "levees" in business (for details see here , or send me an email). Four classes of levees exist, but only two of those interest us here - barriers against the flow of information ("information levees"), and barriers against exit from an industry ("exit levees").
With this background, I now proceed to enumerate the principles that can be used to determine the right level of financial regulation.Principle 1. Good regulation focuses on demolishing information levees.
In recent years, ever more complex and innovative financial instruments such as credit default swaps and collateralized debt obligations have allowed risk to be parceled and “traded away”. However, the lack of transparency fostered by these complex instruments is a levee, affording an illusory protection from erosion in asset value. If a company’s risk exposure is hidden behind the levees of non-transparency and complexity, that risk can come home to roost with devastating consequences, as happened with Lehman Brothers, AIG and other institutions. One test of whether excessive complexity is creating levees via information opacity: if you can’t explain a particular financial instrument to a 12-year old, it’s probably too complex (can you explain to a 12-year old what a ‘collateralized debt obligation’ is ?!).
It is important to note that demolishing information levees does not necessarily mean greater disclosure to the regulator or to the investing public; it often simply means that risk should be in plain sight to the the institution's own management. If exposure to “hidden” risk must exist there should be good – preferably quantitative - estimates of that risk. In other words, a financial institution should be required to know what it doesn’t know about its business and its environment.
Principle 2. Good regulation means the judicious creation of exit levees.
Performing their vital role of guarding systemic stability often needs regulators to erect new levees, or to strengthen existing ones. The most important kind of levees that regulators must erect are those that prevent a financial institution from exiting its business (whether planned or catastrophically !) . Indeed, in fulfilling their fundamental role as lender of last resort, regulators act as a levee. And sure enough, several solutions propounded by various quarters to address the predicament faced by Lehman, AIG, as well as other imperiled Wall Street institutions - emergency lines of credit, deposit guarantees, brokering a ‘shotgun marriage’ with a robust institution, equity injection - were illustrations of creating exit levees, or strengthening existing ones.Creating levees is often a solution that demands a high degree of innovativeness. The $700-billion bailout fund created by the US treasury dept. in the past month is another example of such a levee being created. The US Fed's decision to backstop the commercial paper market on Oct. 7th is yet another example.
Principle 3. There should be enough regulation to satisfy principles 1 and 2, and no more.
Thus, in addition to prescribing what regulation should “do”, principles 1 and 2 help us determine the limits of judicious regulation. Any regulatory action that goes beyond what principles 1 and 2 specify would probably be what Goodhart would call excessive regulatory intensity.A regulatory action that claims exception to this principle must pass the strictest cost-benefit test. Needless to say, both private and social costs as well as benefits must be borne in mind.
As an illustration, it is often tempting to suggest that a financial regulator must lay down limits to activities that an institution may engage in. But any such measure must be subjected to the above cost-benefit argument. Example: the 1933 Glass-Steagall act - a piece of regulation that prohibited banks from performing commercial banking and investment banking functions simultaneously - was created in the Depression era, when the benefits of eliminating the potential conflicts of interest and fraud engendered by mixing the two operations were judged to be high. The act was repealed in the 1990s, primarily on the grounds that such a forced separation prevented banks from realizing their full potential (or in other words, incurred a high cost in terms of lost business opportunities).As another illustration, a group of regulators may get together to coordinate their actions. This too is a high-cost approach and must be resorted to in rare and exceptional situations only. (Indeed, the Nov. 15th world summit itself is an example of such coordinated action, but no one would deny that the current financial crisis is an extremely rare event !).
Other oft-mooted regulatory actions such as placing limits on executive pay** at financial institutions do not follow from either principle 1 or 2, and almost certainly will qualify as excessive regulation.
The edifice of capitalism, which teetered on the brink for a few short weeks, has now been saved. But now the world faces the momentous task of fashioning a new financial regulatory regime that envisages a greater role for government. And so, as we expand the role of government in market regulation, the above principles help decide how much regulation is “just right”. __________________________________________________________________________** actually each of the illustrative regulatory actions above - specifying limits to activities, coordinated action , capping executive pay - is in itself an example of levee creation. However, these are not covered by principle 2 as the levees being created by these actions are not of the "exit" kind - they belong to other classes of levees.
Comments
Agreed. The approach should be central to save the common man who doesn't understand finer grains of risk and reward equation of the complex financial world.
If my memory serves me right, third pillar of Basel II is designed to allow the market to have a better picture of the overall risk position of the bank to allow the counterparties of the bank to price and deal appropriately. The basic asumption is that banks should be able to understand total risk of their financial products and operations.
Tigheting the regulatory screw may tilt the balance in favor of too much security which will finally compromise on market efficiency. The world is searching for this finer balance which lies with banks.
Let me go back to history. I read a quote where Arthur Burns, the then Chairman of the US Federal Reserve, telling Walter Wriston, Citibank chairman: “Walter, you are absolutely wrong to have an earnings target for a bank. It is not seemly.” In those days, banking was a quasi-public utility and not a “business” aimed at maximising earnings of share-holders, traders and top management.
After seeing what has happened in the US banking industry since the sub-prime credit crisis, one is tempted to exclaim: “Mature? Heck, NO! Just greedy and incompetent!”
So, banks have to work as a public utility and probably we may take 1-2 steps in this direction during the coming meeting.
In my opinion, the existing laws and regulations are good enough to avoid it happening in future. Probably with increasing frequency of reporting bank's risk portfolio on a monthly basis to regulators may be a fruitful solution where financial institutions have to get regulatory approval to launch financially innovative products.
Posted by: Santosh Singh | November 11, 2008 1:30 PM
I read RBI Governor speech (The Link: http://www.rbi.org.in/scripts/BS_ViewBulletin.aspx). It gives a central banker perspective on the current financial turmoil and the way ahead.
Posted by: Santosh Singh | November 13, 2008 12:26 PM