Very high levels of regulatory capital diminish bank lending.

TO BE NOTED: Via the Economist's View:

Economic Letter—Insights from the Federal Reserve Bank of Dallas

Vol. 4, No. 3
April 2009
Federal Reserve Bank of Dallas

Seeking Stability: What’s Next for Banking Regulation?
by Simona E. Cociuba

Rules on bank capital have been a key element of banking regulation for many years. The Basel Capital Accord of 1988, known as Basel I, established a common framework to measure capital and set minimum standards for international banks. One of the main goals was to ensure the soundness and stability of the international banking system.[1]

Currently, many countries are adopting a revised framework, known as Basel II.[2] The new accord refines Basel I's crude measure of bank capital and adds rules on bank supervision and transparency.

Despite improvements over the years, capital regulation failed to ensure stability of the financial system in the crisis that flared in the summer of 2007. The billions of dollars of write-downs on assets related to subprime mortgages raised fears of insolvency and led to lending freezes and liquidity problems at many institutions.

Some banks heavily reliant on short-term funding, such as Britain's Northern Rock, experienced runs. Others found themselves with a need to replenish rapidly deteriorating capital positions. All in all, the recent events underscore the need for further revisions in banking regulation.

The Two Basel Accords
The regulation of bank capital aims to ensure bank solvency and reduce costs associated with bank defaults. Bank failures have systemic costs that lead to financial system disruptions and losses not fully borne by failing institutions. Forcing banks to hold adequate capital reduces these losses. Of course, there's a tradeoff: Very high levels of regulatory capital diminish bank lending. Thus, capital regulation's goal is to protect the system against default costs while promoting healthy bank lending.

In practice, calculations of minimum regulatory capital are based on the credit risk of bank assets. The guidelines formulated by the Basel Committee on Banking Supervision call for a bank to hold capital of at least 8 percent of the total value of assets adjusted for individual risk.

One of Basel I's shortcomings was that assets were grouped in very coarse risk categories, so banks' regulatory measure of risk could differ substantially from their actual risk. For example, all business loans received the same weight, despite large differences in risk among borrowers. As a result, the Basel committee revised the accord in June 2004. The major change, introduced by Basel II, was a more risk-sensitive measure of capital (see box, "Calculating Capital Requirements").

While Basel II improves on some aspects of Basel I, it still raises some of the same concerns.

First, the potential to mismeasure risk remains. The new rules for credit risk work well only insofar as the estimates produced by banks' internal models accurately reflect underlying risks. Problems may appear, for example, in evaluating new assets for which little reliable historical data exist.

A second concern is that capital requirements exacerbate macroeconomic fluctuations. In a downturn, a bank's capital is likely to deteriorate due to loan losses. At the same time, the bank's nondefaulting borrowers are likely to be downgraded, forcing the bank to hold more capital against its now riskier loan portfolio. If the bank is unable to raise more equity—as is often the case in a downturn—it will have to limit lending, worsening already adverse economic conditions.

Third and most important, risk-based capital regulation may be inadequate for protecting the financial system. Capital requirements may promote stability of individual institutions. However, ensuring each bank's stability doesn't necessarily guarantee the stability of the system as a whole.

A simple example shows how prudent action by one financial institution may undermine another.[3] Suppose Bank 1 borrows from Bank 2. Bank 2 has other loans on its books and suffers losses on them. Its capital reduced, Bank 2 decides to curtail its lending to Bank 1, even though Bank 1 is a creditworthy borrower.

Bank 2's reduction in lending represents a prudent move that strengthens its capital position. From Bank 1's point of view, however, Bank 2's action amounts to a withdrawal of lending. Bank 1 will need to find an alternative source of funding or reduce its asset holdings. If Bank 1 holds illiquid assets and doesn't obtain new lending, Bank 2's reduction in lending will feel like a run for Bank 1 (see box, "Capital Regulation: A System Perspective").

This example illustrates that routine links between institutions create risks that aren't addressed by capital regulations. In the current financial crisis, the fate of a British bank made this quite clear.

The Run on Northern Rock
U.K. mortgage lender Northern Rock, the first bank to fail in the current crisis, faced a run similar to that of Bank 1 in the example.[4] As the short-term and interbank lending markets froze in mid-2007, Northern Rock ran into funding problems, even though it had virtually no subprime lending.

On July 25, 2007, Northern Rock published its interim report for the year. The chief executive acknowledged that annual profits would be affected by recent sharp increases in money market borrowing rates but concluded that "the medium term outlook for the Company is very positive." On Sept. 14, the Bank of England granted emergency liquidity support to Northern Rock. This was the first run on a U.K. bank since 1866. Northern Rock was taken into public ownership in February 2008.

What went wrong during those two months in 2007, and why did it lead to Northern Rock's fall?[5] In short, troubles with U.S. subprime mortgages led to sharp increases in spreads on asset-backed securities that summer, causing a worldwide liquidity freeze in short-term markets.

Entities that had relied on these markets for funding, such as structured investment vehicles, ended up tapping their bank lines of credit. In turn, banks began to hoard liquidity due to uncertainty about future liquidity needs, causing a freeze in the wholesale markets. Northern Rock was vulnerable because it had relied heavily on wholesale funds.[6]

Northern Rock engaged primarily in residential lending in the U.K. From 1998 until June 2007, the bank expanded its balance sheet aggressively and became Britain's fifth-largest mortgage lender. Total assets increased from £17.4 billion to £113.5 billion. This growth was accompanied by a reduction in retail deposits from 60 percent of total liabilities to 21 percent.

By June 2007, most of Northern Rock's funding came from securitized notes, wholesale markets and other sources (Chart 1). Accounting rules dictated that the securitized notes appear on Northern Rock's balance sheet.[7] Unlike the short-term asset-backed commercial paper at the heart of the subprime crisis in the U.S., these notes had relatively long maturities, averaging about three and a half years.[8]

Click to enlarge

The Northern Rock run started with a nonrenewal of its short- and medium-term wholesale borrowing. When the Bank of England announced it would rescue Northern Rock, retail customers started withdrawing deposits as well. Some queued at branches to demand their deposits, while others struggled to access the bank's website to withdraw funds.[9]

Snapshots of Northern Rock's liabilities before and after the run show one striking change—the loan from the Bank of England (Chart 2). The loan amounted to about a quarter of total liabilities in December 2007. Moreover, both wholesale and retail funding declined to less than half of what they were before the run.

Click to enlarge

In the first half of 2008, the composition of Northern Rock's liabilities saw little change. Retail deposits recovered a bit after the government guaranteed deposits, and the bank repaid part of the Bank of England loan.

Capital and Leverage at Northern Rock. On the eve of the crisis, Northern Rock was complying with its capital requirements. In fact, it had excess capital. On June 29, 2007, the mortgage lender received approval from its regulator, the Financial Services Authority, to switch to the Basel II advanced approach and calculate risk weights for its assets using the bank's internal models. This resulted in a 45 percent decline in total risk-weighted assets. According to the 2007 interim report, Northern Rock's risk weights for residential mortgages were reduced to the mid-teens.

Northern Rock suddenly found itself with excess capital. In December 2006, the capital ratio was 11.6 percent under Basel I calculations, but it jumped to 17.5 percent under Basel II (Chart 3). By June 2007, the Basel II capital ratio had risen to 18.2 percent, well above the bank's regulatory and internal requirements.

Click to enlarge

Not foreseeing the storms on the horizon, Northern Rock announced a 30 percent increase in its interim dividend, scheduled to be paid in October 2007. However, losses incurred after June 2007 led to a deterioration of the bank's equity, and its capital ratio declined to a record low of 10.2 percent in mid-2008. The dividend was canceled.[10]

One problem with Northern Rock was its high leverage: It relied heavily on debt to finance its assets.

Leverage is procyclical—high in booms and low in downturns. In good times, investors are willing to lend more per dollar of bank equity, allowing banks to increase their leverage.

When economic and financial conditions turn sour, however, investors demand a larger equity cushion to protect themselves from losses. Banks find themselves needing to deleverage—that is, cut their debt. Some institutions adjust their balance sheets by raising new equity or selling assets to repay some debt. Northern Rock wasn't one of them.

Leverage, the ratio of total assets to equity, can be calculated using alternative equity measures. Common equity is held by bank owners with voting power. Shareholder equity is common equity plus preferred shares. For Northern Rock, leverage on both common and shareholder equity were already high when they spiked after mid-2007 (Chart 4).

Click to enlarge

Financial experts favor common equity when computing banks' leverage.[11] By this measure, Northern Rock's leverage was 58.2 as of June 2007. It jumped to 86.5 by the end of the year in response to equity losses, and it was even higher in mid-2008. These figures are large by U.S standards: Leverage of U.S. investment banks, for example, is around 25 or 30.[12]

Securitized notes are part of the Northern Rock balance sheet, and this leads to higher measures of leverage. Even if the securitized notes were off the balance sheet, leverage on common equity would still have been high: about 35 in June 2007, 52 at the end of that year and about 100 in June 2008. The high leverage made Northern Rock vulnerable to reductions in funding—an unsettling position for a bank that complied with its capital requirements.

Strengthening Bank Regulation
The run on Northern Rock raises important questions about how to revise banking regulation. As it stands, the international standard embodied in Basel II has a few shortcomings. Among them is that capital regulation exacerbates economic downturns because banks choose to curtail lending when capital is scarce.[13]

Ideally, bank regulation seeks to balance two opposing objectives: reducing the cost of bank defaults and ensuring efficient lending. As a result, in a downturn, when banks are capital-constrained, it is desirable to adjust both. However, Basel standards require that the probability of bank defaults be fixed over time. When economic conditions turn sour, lending bears the brunt.

A proposed solution involves allowing slightly higher bank default probabilities in a downturn. This would mean that as the risk of an asset goes up, the capital the bank is required to hold against that asset won't rise as sharply as it does now.[14]

Recent events show that risk-based capital measures may be inadequate for promoting stability of the financial system. Proposals to mitigate this problem include complementing the rules on bank capital with rules on liquidity and leverage.[15] The rationale for liquidity regulations is that banks with more liquid assets or stable, illiquid liabilities are less vulnerable in the face of a run. A leverage constraint would limit the amount of debt a bank can take on during booms and thus reduce the need to deleverage in bad times.[16]

Under a different regulatory scheme, Northern Rock might not have experienced the run that led to its collapse. If future regulations limit spillover effects among banks, they could reduce the chances for financial crises and the resulting damage to economies.

Calculating Capital Requirements Capital has two components. Tier 1—or core capital—consists of equity capital, such as common stock, and disclosed reserves, such as those from retained earnings. Tier 2—or supplementary capital—includes elements like perpetual cumulative preferred shares and subordinated debt with maturity greater than five years. Under the Basel accords, total capital must be at least 8 percent of risk-weighted assets. Core capital must be at least half of that.[1] Under Basel I … In computing risk-weighted assets, the assets and off-balance-sheet activities of a bank are grouped into four categories that reflect the degree of credit risk—zero, 20, 50 or 100 percent. Cash or claims on central banks denominated in national currency are considered virtually risk free and given a weight of zero. Loans fully secured by a mortgage on residential property have a weight of 50 percent. All business loans are given a weight of 100 percent, even though risk varies greatly depending on the borrower. Off-balance-sheet items are first converted into on-balance-sheet items using credit conversion factors and then receive an appropriate risk weight. Under Basel II … An asset’s credit risk is calculated using one of two approaches. The standardized approach bases risk weights on ratings by external agencies. The internal-ratings-based (IRB) approach has two versions, both of which use several parameters to measure risk weights. Main parameters include the probability of default, the loss given default, the exposure at default and the maturity of the asset. Banks that operate under the “foundation” version of the IRB approach compute their own estimate for the probability of default, while the other three parameters are set by the Basel committee. Banks that operate under the “advanced” version estimate the four parameters according to their own internal models. Basel II introduces a more refined measure of credit risk. For example, risk weights for residential mortgages under the IRB approach vary greatly (see table). IRB Risk Weights for Residential Mortgages Probability of default (percent) Risk weight (percent) .03 4.15 .25 21.30 .50 35.08 1.00 56.40 2.50 100.64 5.00 148.22 10.00 204.41 20.00 253.12 NOTE: The risk weights are computed for loss given default of 45 percent. SOURCE: Basel Committee on Banking Supervision, June 2006. 1. Under Basel II, banks may also employ a third tier of capital at the discretion of their national authority, consisting of short-term subordinated debt. For details, see “International Convergence of Capital Measurement and Capital Standards: A Revised Framework, Comprehensive Version,” Basel Committee on Banking Supervision, Bank for International Settlements, Basel, Switzerland, June 2006.

Capital Regulation: A System Perspective The balance sheets provide simple illustrations of the assets and liabilities of two banks (below). Both banks need to comply with a capital-requirement ratio of 8 percent and a reserve-requirement ratio of 10 percent. If reserves carry a risk weight of zero and all loans carry a risk weight of 1, both banks have risk-weighted assets equal to $91. Their capital ratios are $10/$91, about 11 percent. Moreover, the banks hold $1 of reserves for each $10 of deposits, so the reserve ratio is met as well. Suppose that Bank 2 suffers a credit loss of $2.50 on its loans to customers other than Bank 1. Bank 2’s equity capital is reduced to $7.50 and total assets now equal $97.50. If the risk weight for all nondefaulted loans remains unchanged, Bank 2’s capital ratio declines to $7.50/$88.50, about 8.5 percent. To strengthen its capital position, Bank 2 decides to renew only three-fourths of the loan it made to Bank 1 and to hold excess reserves. The new balance sheet of Bank 2 shows that the capital ratio is 9.3 percent and the reserve ratio is 18.3 percent (below). Bank 2 took a cautious action and strengthened its books. From the perspective of Bank 1, however, the reduction in Bank 2’s lending is a withdrawal of funds. Bank 1 has a problem: Its reserves are depleted, and it has to either find funding elsewhere or reduce its assets (below). If Bank 1’s loans are illiquid—for example, residential mortgages—and the bank can’t find alternative sources of funds, the withdrawal of funds will feel like a run. Suppose that the central bank comes to Bank 1’s rescue by extending a loan of $7.50. Bank 1’s new balance sheet is shown below.

About the Author Cociuba is a research economist in the Federal Reserve Bank of Dallas' Globalization and Monetary Policy Institute. Notes For details, see "International Convergence of Capital Measurement and Capital Standards," Basel Committee on Banking Supervision, Bank for International Settlements, Basel, Switzerland, July 1988. The Basel accords are formulated by the Basel committee. As of March 2009, the committee's members are officials from 20 countries: Australia, Belgium, Brazil, Canada, China, France, Germany, India, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Spain, Sweden, Switzerland, the U.K. and the U.S. However, other countries are voluntarily adopting similar rules. According to a 2008 survey by the Financial Stability Institute, about 105 countries (including 92 nonmember countries) had implemented or were planning to implement Basel II. This example is discussed in "Financial Regulation in a System Context," by Stephen Morris and Hyun Song Shin, Brookings Papers on Economic Activity, no. 2, Fall 2008, pp. 229–74. For a detailed analysis of bank loss spillovers to the financial system via interbank linkages, see "Financial Contagion," by Franklin Allen and Douglas Gale, Journal of Political Economy, vol. 108, no. 1, 2000, pp. 1–33. For a discussion of Lehman Brothers and Bear Stearns, see note 3, Morris and Shin. This section draws on "Reflections on Northern Rock: The Bank Run that Heralded the Global Financial Crisis," by Hyun Song Shin, Journal of Economic Perspectives, vol. 23, no. 1, 2009, pp. 101–19. Also see note 3, Morris and Shin. For analysis of the impact of the Northern Rock experience on the U.K. banking system, see "Liquidity, Bank Runs and Bailouts: Spillover Effects During the Northern Rock Episode," by Tanju Yorulmazer, Federal Reserve Bank of New York Working Paper, Feb. 1, 2009. The paper is available for download at http://ssrn.com/abstract=1107570. Wholesale funds are obtained from nonfinancial corporations, money market mutual funds, foreign entities and other financial institutions. Typically, the funds are raised on a short-term basis through instruments such as certificates of deposit, commercial paper, repurchase agreements and federal funds. The "Financial Stability Report," published in April 2007 by the Bank of England, highlights dangers of heavily relying on wholesale funding. Northern Rock was aware of these warnings and took some steps to change its lending and funding strategies. For details, see "The Run on the Rock," House of Commons Treasury Committee, Fifth Report of Session 2007–08, vol. 1, January 2008, pp. 14–5. For more on wholesale funding, refer to "The Dark Side of Bank Wholesale Funding," by Rocco Huang and Lev Ratnovski, Federal Reserve Bank of Philadelphia, Working Paper no. 3, 2009. Northern Rock operates under the International Accounting Standards Board's International Financial Reporting Standards (IFRS). The standards require that securitized vehicles be part of a bank's consolidated balance sheet (for more on the consolidation of special-purpose entities, for example, see IFRS 2006, pp. 2227–34). For a detailed discussion of the securitization process and how it differs in the U.S., see note 5, Shin. See note 6, House of Commons Treasury Committee, p. 13. As of June 30, 2007, 23 percent of total retail deposits were traditional branch accounts. Postal accounts, Internet accounts and telephone accounts were about 60 percent of total retail deposits, and offshore accounts were about 16 percent. Withdrawals on postal accounts accounted for about 40 percent of the decline in retail deposits observed between June and December 2007. Withdrawals on Internet, offshore and branch accounts each accounted for about 19 percent of the decline. See Northern Rock's 2007 annual report, p. 36. The annual and interim reports can be downloaded from http://companyinfo.northernrock.co.uk/investorRelations/results/. Common equity grants control over the bank's operation and thus assures the lender that its investments are protected from loss. For a formal analysis, see note 3, Morris and Shin, and note 5, Shin. For a plot of average leverage of U.S. investment banks since 1992, see Figure 3.10 in "Liquidity and Leverage," by Tobias Adrian and Hyun Song Shin, Federal Reserve Bank of New York Staff Reports, no. 328, May 2008. To mitigate this problem, Spain in 2000 introduced a regulation called dynamic provisioning, which forces banks to increase their capital in booms to be able to draw on these reserves in downturns, when the need for capital is larger. For more detail on this subject, see "Cyclical Implications of the Basel II Capital Standards," by Anil K. Kashyap and Jeremy C. Stein, Federal Reserve Bank of Chicago Economic Perspectives, vol. 28, 2004, pp. 18–31, and "Procyclicality in Basel II: Can We Treat the Disease Without Killing the Patient?" by Michael B. Gordy and Bradley Howells, Journal of Financial Intermediation, vol. 15, 2006, pp. 395–417. The U.S. already has in effect a leverage ratio constraint. In 1991, Congress enacted the Federal Deposit Insurance Corporation Improvement Act, known as FDICIA, which requires that banks have equity capital of at least 2 percent of total assets. For details on FDICIA, see "Reforming Deposit Insurance and FDICIA," by Robert A. Eisenbeis and Larry D. Wall, Federal Reserve Bank of Atlanta Economic Review, vol. 87, no. 1, 2002. The idea of a leverage ratio constraint also gained support recently in Switzerland. For details, see "Is Basel II Enough? The Benefits of a Leverage Ratio" (Speech by Philipp M. Hildebrand of Swiss National Bank at the Financial Markets Group Lecture, London School of Economics, London, Dec. 15, 2008). For more detail on liquidity and leverage constraints, see note 3, Morris and Shin.

Economic Letter is published monthly by the Federal Reserve Bank of Dallas. The views expressed are those of the authors and should not be attributed to the Federal Reserve Bank of Dallas or the Federal Reserve System.

Articles may be reprinted on the condition that the source is credited and a copy is provided to the Research Department of the Federal Reserve Bank of Dallas.

Economic Letter is available free of charge by writing the Public Affairs Department, Federal Reserve Bank of Dallas, P.O. Box 655906, Dallas, TX 75265- 5906; by fax at 214-922-5268; or by telephone at 214- 922-5254. This publication is available on the Dallas Fed web site, www.dallasfed.org.

"any fissure in this regulatory structure will lead to a race to the bottom."

TO BE NOTED: From the WaPo:

"Plan to Expand Financial Oversight May Add New Risks

By Zachary A. Goldfarb
Washington Post Staff Writer
Tuesday, April 7, 2009; A17

The Obama administration's plan for a sweeping expansion of financial regulations could have unintended consequences that increase the very hazards that these changes are meant to prevent.

Financial experts say the perception that the government will backstop certain losses will actually encourage some firms to take on even greater risks and grow perilously large. While some financial instruments will come under tighter control, others will remain only loosely regulated, creating what some experts say are new loopholes. Still others say the regulation could drive money into questionable investments, shadowy new markets and lightly regulated corners of the globe.

And a shortage of manpower raises questions about the government's ability to keep up with the vast and complex financial markets.

In congressional testimony last month, Treasury Secretary Timothy F. Geithner laid out the principles of the administration's proposals. He called in part for designating a federal agency that would be responsible for identifying financial companies whose failure could endanger the wider economy and for giving the government greater authority to wind down troubled financial firms. He also proposed new regulations for hedge funds, venture capital funds and private-equity funds, as well as for complex financial instruments known as derivatives.

These plans seek to mitigate some of the dangers exposed by the financial crisis. But while weak regulation is partly responsible for the current turmoil, the unintended consequences of government action over past decades also played a role.

At the top of the Obama administration's agenda is the creation of a regulator that can peer into any corner of the economy to root out threats that could shatter financial markets.

But some experts warn that such a "systemic risk regulator" could unleash new hazards if it can identify certain companies as being too large to fail. This could create an incentive for firms to grow dangerously big so they can win a government guarantee against failure. If a company has the promise of government protection, its creditors might be willing to lend it money at below-market rates because of the reduced probability the company will collapse and they won't get paid back.

The danger of this incentive is twofold. For one, a firm may be willing to take on more unreasonable risks. Second, if a company gets access to unusually cheap financing, its rivals are at a competitive disadvantage.

"If these entities are now perceived to be too big to fail within the protective net, then they get an advantage vis-à-vis other institutions that are not so perceived," said Lawrence White, an economics professor at New York University. "The creditors to these guys become even less inclined to monitoring and more inclined to say, 'Hey, let the government do it.' "

In the view of many financial experts, that is exactly what happened to mortgage-finance companies Fannie Mae and Freddie Mac before the government seized them last year. Congress chartered both companies to provide financing to lenders to make home mortgages. Their debt didn't carry the official backing of the U.S. government, but many creditors assumed the government would step in if the companies faltered.

That meant the interest rates Fannie Mae and Freddie Mac had to pay to borrow were just slightly higher than what the U.S. government had to pay. With access to cheap financing, the firms borrowed hundreds of billions of dollars and bought or guaranteed trillions of dollars in mortgages. Some of these went bad in recent years. Last fall, the companies nearly collapsed as a result, prompting the government takeover.

Geithner's proposals for hedge funds and derivatives also drew concerns from some financial experts. Geithner proposed that hedge funds register with the Securities and Exchange Commission and disclose information about their operations.

But some who closely track the industry warn that may encourage more investors to put their money into hedge funds without actually protecting against fraud and risky investment practices.

"The government is going to be more hands-on, and that's going to imply to people the government is vetting the risks relevant to a hedge fund," said Jason Scharfman, managing director of Corgentum, a firm that evaluates whether hedge funds have proper safe internal procedures. "It exposes investors to a false sense of security that they don't need to perform adequate due diligence on the hedge funds they're investing with."

The SEC and other agencies may not have the manpower to adequately oversee new markets.

In recent months, the SEC has disclosed that the number of agency staffers available to police the market has stagnated even as the size and complexity of the market has grown far greater. For instance, only one in 10 investment advisers -- the designation under which most hedge funds register -- is examined every year by the SEC.

Meanwhile, the special inspector general overseeing the Treasury Department's financial recovery plan has just 30 employees. The inspector general's chief of staff recently said that his operation would need an agency the size of the FBI -- which has nearly 30,000 employees -- "to truly cover this by ourselves."

In his testimony on the future of regulation, Geithner also said that most derivatives should be regulated. Of particular concern are credit-default swaps, which are essentially insurance contracts between two parties to cover losses should a bond default. These swaps were behind the near-collapse of American International Group. And because trillions of dollars of swap agreements were made over recent years, it was difficult for the government to determine the extent to which they posed a threat to the entire financial system when the crisis escalated last fall.

Geithner proposed that swaps be traded through a central clearinghouse, allowing regulators to keep an eye on the derivatives market and give investors more confidence that their partners are legitimate. This would apply to standard swaps -- for instance, one to protect against a General Electric bond going bad.

But others would be exempt. This would include nonstandard swaps, such as one to protect against the default of a multilayered security composed of residential and commercial mortgages.

Several experts cautioned that leaving any room for exemptions could be devastating.

"It could give incentives for parties to issue less standardized or very customized contracts which would not be required to be cleared," said Houman Shadab, senior research fellow at the Mercatus Center at George Mason University.

There could be a rush to use nonstandard swaps if there's an opportunity to get around a clearinghouse, which would impose additional costs.

Michael Greenberg, a University of Maryland law professor and former top official at the Commodity Futures Trading Commission, said "any fissure in this regulatory structure will lead to a race to the bottom."

The Obama administration's initiative also poses a risk that financial firms will move their activities offshore to avoid heightened regulation. Last week big industrial nations met in London to work on international regulatory reform, and some European countries want even tighter regulation than does the United States. But that doesn't solve the problem of lightly regulated island regimes such as the Cayman Islands or Netherlands Antilles, or developing financial centers in Asia and the Middle East.

"More regulation here will undoubtedly lead to more money flowing to places with a less heavy regulatory framework, in an effort to keep costs down," Andrew P. Morriss, a professor who studies regulation at the University of Illinois at Urbana-Champaign, said in an e-mail.

Morriss warned that money currently flowing into the United States from international investors could go elsewhere, such as China, "if we try to make it hard to come here."

Maybe the hedgies are finally realizing that the only thing worse than too much regulation is too little.

From Reuters:

"When hedge funds embrace regulation

Post a comment (1)

Posted by: Felix Salmon

Tags: hedge funds, regulation

Paul Singer, the ardent Bush supporter and laissez-faire capitalist who runs the $13 billion Elliott Associates hedge fund, has an astonishing op-ed in today’s WSJ:

Now we must create a new regulatory infrastructure that will meet three fundamental tests… finally, it must bring all investors and traders — regardless of whether the risk holder is a hedge fund, bank, private equity fund, individual or government agency — under the regulatory umbrella…
I understand the inclination among free-market conservatives to dismiss the government’s regulatory efforts as misguided. Some government actions over the past year have been reactive and incomplete. Yet these actions have been large and reasonably fast, which were the critical elements for the survival of the system.

The op-ed comes in the wake of the G20 meeting which agreed that hedge funds should be regulated, so maybe Singer is simply bowing to reality here. But this is still something of a watershed moment. Singer is one of the most politically astute hedge-fund managers in America, and where he goes the rest of the industry is probably likely to follow.
So if you thought there would be a lot of pushback from the hedge-fund industry against proposals to regulate it, think again. The industry will want a say in how any legislation is worded, of course. But it has also lost hundreds of billions of dollars over the past couple of years as a result of insufficient regulation of the global financial system. Maybe the hedgies are finally realizing that the only thing worse than too much regulation is too little."

Me:

It’s an excellent post:

“But this crisis was primarily caused by managements and individuals throughout the financial system who exercised extremely poor judgment. The private sector, not the public sector, is where the biggest mistakes were made.”

Bingo!

“Government action could easily spill over into gross over-reach (like the bonus-tax fiasco). But a combination of private responsibility and practical government regulation will help ensure that the capitalist system continues to be a source of opportunity and prosperity for people throughout the world.”

Can you say “libertarian Democrat”?

Here’s a comment from long ago:

“Saturday, October 4, 2008
The Path To Re-Regulation
Gross on regulation resulting from this crisis:

“In the meantime, a surge in regulation of the financial sector will be unleashed, probably an inevitable result of the problems and rescues of recent months.

“Twelve to 24 months down the road, all of these high-flying investment banks and banks will be reregulated and downsized,” Mr. Gross said. “They won’t become arms of the government, but they will be supervised and held on a tight leash.”

The greater regulation should draw investors back to the market and away from what seems to be their current financial strategy — stuffing their cash in mattresses.”

One of the probable downsides of a crisis like this is the problem of over-regulation resulting, which is why I favor enough regulation to keep this kind of crisis from occurring. However, as even Gross admits, some regulation is necessary for investors to re-enter the market. Let’s hope we strike a better balance this time.”

In other words, you actually need regulation in order to:
1) Get people investing again
2) Get people to buy into our system at all

I also agree here:

“Reform must begin with a regulatory regime focused on “behavior” instead of “systemically important institutions.” Today, even small entities that trade complex instruments or are granted sufficient leverage can threaten the global financial system.”

Choose Human Agency Explanations over Mechanistic ones if you want to do some real good.

Finally, congratulations on your new venue. Reuters is terrific. For one thing, they had some of the earliest reporting on the possible social disruptions and dislocations in this crisis.

As well, their page on African news is the best I’ve found. Try it:

http://af.reuters.com/

- Posted by Don the libertarian Democrat

From the WSJ:

"By PAUL SINGER

President Barack Obama took his proposed financial regulatory reforms to London this week for the G-20 meeting, while free-market advocates objected. While many of Mr. Obama's ideas warrant skepticism, conservative opposition to any expanded role for government is a mistake. There is an urgent need for a new global regulatory initiative that addresses the primary cause of the financial collapse: highly leveraged and concentrated positions.

Reform must begin with a regulatory regime focused on "behavior" instead of "systemically important institutions." Today, even small entities that trade complex instruments or are granted sufficient leverage can threaten the global financial system.

It's true that monetary policy was too lax for too long, and the government encouraged lending to people who were unlikely to repay their loans. But this crisis was primarily caused by managements and individuals throughout the financial system who exercised extremely poor judgment. The private sector, not the public sector, is where the biggest mistakes were made.

In the past decade, most global financial institutions built highly leveraged balance sheets -- sometimes as high as 30 to 1 -- that were stuffed with risky assets. These institutions also bought on a large scale for their own accounts the same securities they sold to their customers. Our anachronistic regulatory framework didn't catch the problems, and warped incentives and compensation schemes fueled the risk-control failures that eventually brought on the crisis we face today.

Now we must create a new regulatory infrastructure that will meet three fundamental tests. First, it must assess and measure risks accurately, including the compounded risks of herding (traders being similarly situated and forced to unwind simultaneously). Second, it must impose significant margin requirements on all exposures. And finally, it must bring all investors and traders -- regardless of whether the risk holder is a hedge fund, bank, private equity fund, individual or government agency -- under the regulatory umbrella. These three measures will diminish volatility and reduce the likelihood of a future financial collapse.

Creating a regulatory system that reflects the modern-day realities of financial markets is not as difficult as it may appear. The financial structures that destabilized our markets have definable characteristics. They are either long or short (and have a particular exposure to) the movement of an underlying asset, index, or instrument (such as a tranche of mortgage-backed security).

It is critical that any new regulatory initiative have a global mandate and contain mechanisms to prevent "risk infection" by countries that try to dodge risk controls. There are legitimate concerns about the time needed to devise a global risk-management system and staff it with individuals with the requisite sophistication and experience. But there are relatively simple solutions.

First, the government can hire private firms to assist in assessing risks posed by complicated financial instruments. Despite the failure of financial CEOs to understand the wizardry invented by their own "rocket scientists," there are independent firms such as Duff & Phelps that can make sense of these products and serve as objective advisers.

Second, interim steps can be adopted to immediately rein in leverage and risk, such as increasing margin requirements for certain types of instruments. For example, in order to initiate credit default swaps, all parties (including dealers, who currently put up little or nothing) should be required to post deposits or reserves of at least 15%, if hedged against a credit instrument of the same company, and 30% otherwise.

And, given that there are many long-standing programs of position reporting, it would not be revolutionary to implement globally-enforced reporting for large positions related to equities, real estate, currencies, commodities and interest rates. But this would only be effective if these positions were accurately analyzed in terms of their exposure to the movement of the underlying reference assets, regardless of the form of the positions or existing regulatory coverage.

I understand the inclination among free-market conservatives to dismiss the government's regulatory efforts as misguided. Some government actions over the past year have been reactive and incomplete. Yet these actions have been large and reasonably fast, which were the critical elements for the survival of the system.

Government action could easily spill over into gross over-reach (like the bonus-tax fiasco). But a combination of private responsibility and practical government regulation will help ensure that the capitalist system continues to be a source of opportunity and prosperity for people throughout the world.

Mr. Singer, founder and CEO of Elliott Management Corp., is chairman of the Manhattan Institute and on the board of Commentary magazine."

the real high-stakes poker involves choosing a new philosophy for the international financial system and its regulation.

TO BE NOTED: From Korea Times via the Economist's View:

Brave New Financial World

By Kenneth Rogoff
Project Syndicate

CAMBRIDGE ― A huge struggle is brewing within the G-20 over the future of the global financial system. The outcome could impact the world ― and not only the esoteric world of international finance ― for decades to come.

Finance shapes power, ideas, and influence. Cynics may say that nothing will happen to the fundamentals of the global financial system, but they are wrong. In all likelihood, we will see huge changes in the next few years, quite possibly in the form of an international financial regulator or treaty.

Indeed, it is virtually impossible to resolve the current mess without some kind of compass pointing to where the future system lies.

The United States and Britain naturally want a system conducive to extending their hegemony. U.S. Treasury Secretary Timothy Geithner has recently advanced the broad outlines of a more conservative financial regulatory regime.
Even critics of past U.S. profligacy must admit that the Geithner proposal contains some good ideas.

Above all, regulators would force financiers to hold more cash on hand to cover their own bets, and not rely so much on taxpayers as a backstop.

Geithner also aims to make financial deals simpler and easier to evaluate, so that boards, regulators, and investors can better assess the risks they face.

While the rest of the world is sympathetic to Geithner's ideas, other countries would like to see more fundamental reform.

Russia and China are questioning the dollar as the pillar of the international system. In a thoughtful speech, the head of China's Central Bank, Zhou Xiaochuan, argued the merits of a global super-currency, perhaps issued by the International Monetary Fund.

These are the calmer critics. The current president of the European Union's Council of Ministers, Czech Prime Minister Miroslav Topolanek, openly voiced the angry mood of many European leaders when he described America's profligate approach to fiscal policy as ``the road to hell."

He could just as well have said the same thing about European views on U.S. financial leadership.

The stakes in the debate over international financial reform are huge. The dollar's role at the center of the global financial system gives the U.S. the ability to raise vast sums of capital without unduly perturbing its economy.

Indeed, former U.S. President George W. Bush cut taxes at the same time that he invaded Iraq. However dubious Bush's actions may have been on both counts, interest rates on U.S. public debt actually fell.

More fundamentally, the U.S. role at the center of the global financial system gives tremendous power to U.S. courts, regulators, and politicians over global investment throughout the world. That is why ongoing dysfunction in the U.S. financial system has helped to fuel such a deep global recession.

On the other hand, what is the alternative to Geithner's vision? Is there another paradigm for the global financial system?

China's approach represents a huge disguised tax on savers, who are paid only a pittance in interest on their deposits. This allows state-controlled banks to lend at subsidized interest rates to favored firms and sectors.

In India, financial repression is used as a means to marshal captive savings to help finance massive government debts at far lower interest rates than would prevail in a liberalized market.

A big part of Russia's current problems stems from its ill-functioning banking system. Many borrowers, unable to get funding on reasonable terms domestically, were forced to take hard-currency loans from abroad, creating disastrous burdens when the ruble collapsed.

Europe wants to preserve its universal banking model, with banks that serve a broad range of functions, ranging from taking deposits to making small commercial loans to high-level investment-banking activities.

The U.S. proposals, on the other hand, would make universal banking far harder, in part because they aim to ring-fence depository institutions that pose a ``systemic risk" to the financial system.

Such changes put pressure on universal banks to abandon riskier investment-bank activities in order to operate more freely.

Of course, U.S. behemoths such as Citigroup, Bank of America, and JP Morgan will also be affected. But the universal banking model is far less central to the U.S. financial system than it is in Europe and parts of Asia and Latin America.

Aside from its implications for different national systems, the future shape of banking is critical to the broader financial system, including venture capital, private equity, and hedge funds.

The Geithner proposal aims to reign in all of them to some degree. Fear of crises is understandable, yet without these new, creative approaches to financing, Silicon Valley might never have been born. Where does the balance between risk and creativity lie?

Although much of the G-20 debate has concerned issues such as global fiscal stimulus, the real high-stakes poker involves choosing a new philosophy for the international financial system and its regulation.

If our leaders cannot find a new approach, there is every chance that financial globalization will shift quickly into reverse, making it all the more difficult to escape the current morass.

Kenneth Rogoff is professor of economics and public policy at Harvard University, and was formerly chief economist at the International Monetary Fund (IMF). For more stories, visit Project Syndicate (www.project-syndicate.org).

A central lesson from this crisis is that small is beautiful.

TO BE NOTED: From the WaPo:

"Geithner on the High Wire
A Rescue Plan Has to Reduce Risk, Not Just Regulate It

By Sebastian Mallaby
Friday, March 27, 2009; A17

In his stunningly ambitious House testimony yesterday, Treasury Secretary Tim Geithner laid out three ways to fix finance. Large players -- be they banks, insurers or hedge funds -- must take less risk. A rejuvenated regulatory machinery must monitor the risks they do take, reining them in when they go too far. And if the first two measures do not prevent the failure of a major institution, the government must have the power to manage its collapse in an orderly fashion.

Geithner's success will depend on being clear that the first line of defense -- prohibiting excessive risk-taking -- is the most important. The financial industry, which makes money from risk, will no doubt argue the opposite. Yes, Mr. Secretary, the industry will say: We love your rejuvenated regulator and your orderly wind-downs. And because you are erecting a wonderful safety net, there's no need to mess with our trapeze act.

It would be nice to be able to agree with this pitch, because trapeze artists bring real benefits. By borrowing large sums, traders magnify the profits they get from funneling the nation's savings to the individuals and companies that use them best. This borrowing, or "leverage," is certainly risky. But it increases the incentive to allocate scarce capital intelligently. More productive capital means more jobs and growth.

Equally, the market for sophisticated derivatives is not just a dangerous casino -- though it certainly can be that. To the contrary, derivatives can actually make some risk vanish, freeing nonfinancial companies to grow. For example, a U.S. exporter might hold back from expanding a factory because of the danger that the dollar will rise, undermining his ability to sell abroad. A U.S. importer might hold back from expanding a store because of the danger the dollar will fall, making imports unattractively expensive. Thanks to currency swaps, these equal and opposing risks can be made to partially cancel one another. The factory and store can move forward with expansion. Again, jobs are created.

Because there are real benefits in sophisticated finance, it would be great to mitigate its risks without hobbling it. Geithner's proposals to eliminate gaps in the regulatory machinery and to shore up swaps trading by moving those transactions into well-capitalized clearinghouses point in the right direction. But regulation will never be perfect. There is no way to escape the basic dilemma: If you want to reduce the risk that finance poses to the real economy, you have to limit the amount of risk that financiers take in the first place.

Consider Geithner's proposal to eliminate overlaps and gaps in financial regulation. As Geithner himself acknowledged, the crazy risks that caused the crisis often occurred at institutions that were fully regulated. London had a unified financial regulator of the sort Geithner advocates; it failed miserably. The promise (both here and in Europe) of a new form of "systemic" regulation will be extremely hard to fulfill. Besides, it is not even clear that the most basic regulatory reforms are politically possible. Members of the congressional committees that oversee the Commodity Futures Trading Commission enjoy the campaign contributions that their power generates, so they have blocked its merger with the Securities and Exchange Commission, even though such a merger would make eminent sense.

What of empowering government to wind down failing financial firms in an orderly fashion? "Orderly" is in reality a euphemism for punishing private creditors in the way they deserve. Under existing rules, the government's takeover of AIG has been perfectly orderly; the problem is that the costs are borne by taxpayers rather than by AIG's traders, bond holders and swaps counterparties, which should have monitored their risks better. But even if the government had enjoyed wider authority, it's not clear that it would have forced private creditors to take losses. After all, government already has broad authority over bank failures. But it has shied away from punishing bond holders of busted banks lest other banks' bond holders panic.

So Geithner's ideas on regulation and wind-downs are sensible, but they won't prevent the next crisis or save taxpayers from the cost. That is why the financial industry must be forced to take less risk. Traders must use less leverage and hold more capital, even if this dulls incentives to allocate savings efficiently. They must be forced to pay a "risk tax" to compensate a public that will foot the bill if they blow up. Moreover, the risk-tax rate must rise as financial firms get bigger. A small hedge fund can blow itself up with crazy leverage and not destabilize the financial system: It should take as much risk as it likes. A big hedge fund, bank or insurer is a different matter. Over the past decade or so, Wall Street has concentrated risk in ever-larger behemoths. A central lesson from this crisis is that small is beautiful.

smallaby@cfr.org"

"a host of measures that would dramatically expand government control over banking and investment in the United States."

From the Washington Post:

"Obama Adviser Presents Plan to Alter Global Financial System

By Anthony Faiola
Washington Post Staff Writer
Thursday, January 15, 2009; 12:27 PM

NEW YORK -- A top economic adviser to the incoming Obama administration unveiled a plan today to radically rethink the global financial system, including a host of measures that would dramatically expand government control over banking and investment in the United States.( HERE WE GO )

The plan -- which recommends limiting the size of banks( IF THEY ARE GUARANTEED, I AGREE ), setting guidelines for executive pay( SHOULD BE DONE BY SHAREHOLDERS. BUT I'M OK WITH IT IF THE BANK IS GUARANTEED ) and regulating hedge funds( SUPERVISING I APPROVE OF ) -- offers the first hint of the kind of changes to the financial system President-elect Barack Obama might push for in the coming weeks and months. Obama has pledged to present a comprehensive series of changes to prevent a repeat of the current financial crisis before world leaders gather in London for a major economic summit in April.

The report today was issued by the Group of 30, an organization of international economists and policy makers. But the recommendations were immediately seen by observers as a building block to an Obama plan because the lead author is Paul Volcker, the former chairman of the Federal Reserve during the Carter and Reagan administrations who will serve as a special Obama White House adviser. Part of Volcker's role is to help mastermind what could ultimately be the biggest overhaul of the U.S. financial system in decades.

Volcker said he would press the new administration to consider the measures, "but it's up to the administration to decide what they want to do."

The proposal offers 18 major recommendations that would insert government regulators into the board rooms of financial institutions as never before. The plan recommends vastly increased oversight of major banks, going as far as to recommend the end of an era of mega banks whose size makes their failure potentially catastrophic to the global financial system. To limit their size and scope, banks, the document states, should be prohibited from managing hedge funds or private equity funds.( AGAIN, IF GUARANTEED, FINE )

In addition, major mutual funds should be required to operate as commercial banks, subjecting them to stricter government oversight. Those that choose not to comply should be forced to sell only relatively safe financial instruments offering investors low risk, and, most probably, limited room for outsized profits.( IF GUARANTEED, YES )

The document suggests that venture capital groups and rating agencies should also face a battery of government regulators.( WON'T WORK. SUPERVISION MIGHT. )

"The issue posed by the present crisis is crystal clear: How can we restore strong, competitive, innovative financial markets to support global economic growth without once again risking a breakdown in market functioning so severe as to put the world economies at risk?" Volcker said in a statement. "We hope that our proposals, which explicitly relate to the weaknesses that have become evident in the financial system over the last year, will be a useful contribution to the debate about needed reforms both by private financial institutions and by public authorities."

The proposal suggests that the U.S. government should clarify the status of mortgage giants Fannie Mae and Freddie Mac, either making them into government agencies or regulating them as independent mortgage brokers.( I AGREE COMPLETELY )

The plan's recommendations for greater international cooperation on regulation and the creation of new laws to oversee( SUPERVISION IS FINE ) exotic financial derivatives echo similar calls from major world leaders made during an emergency economic summit in Washington on Nov. 15. With cautious support by President Bush, plans are moving forward, for instance, to enhance international cooperation in overseeing major banks( A GOOD IDEA ). But European leaders have eagerly awaited a signal from Obama about what his plan for creating a new set of rules for the global financial system might look like.

It remains unclear how many of the recommendations will ultimately make their way into Obama's final plan, but the proposal released today could lift the spirits of Europeans who have called for stricter government oversight on executives' pay and risk management in financial institutions -- an area where the Bush administration has offered only tepid support. The report today calls for government to enforce systematic board-level reviews for executive pay and the creation of new parameters for a firm's risk tolerance."

As I've said, I differentiate between Guaranteed Financial Concerns and Non-Guaranteed Financial Concerns. The guaranteed businesses should have stricter rules and supervision in order to protect the taxpayer. I would prefer that we have a separate category for non-guaranteed concerns that will allow more leeway and innovation. In order to have such a category at all, I would be willing to accept size and asset limitations.

The Place Of Government Guarantees In Avoiding Bank And Calling Runs

I want to briefly talk about the causes of this crisis before the silly explanations like lack of regulations and complex investments win day, as they surely will, guaranteeing that this system will go on and even implode again in the near future, although hopefully not to the this extent.

I want to ask a simple question: Does FDIC Insurance on individual accounts help prevent bank runs? Bank Runs being a result of depositors running to the bank to get their money out before the resources of the bank run dry, leaving a number of depositors to lose their money. If you think that FDIC Insurance is stupid, illegal, unconstitutional, a gift to moral hazard, doesn't help stop bank runs, and should be gotten rid of, then my points going forward won't matter to you. I do, however, address this position at the end of the post.

Now, our current crisis is a Calling Run. As the credit rating of a business goes down, investors or creditors that can demand money from the business do so, forcing the business to sell assets or borrow to fund these calls, which leads to a further deterioration of the finances of the business and a further downgrade, which leads to more calls... Now, if better regulations and higher capital standards are all that is needed to stop runs, why do we need FDIC Insurance? Surely higher capital standards and better regulation should suffice to stop a Bank Run. You see my point.

In the current crisis, the flight to Treasuries was in lieu of an explicit government guarantee concerning their assets. Investors fled into explicitly guaranteed, and hence liquid investments, since they can be priced, and even fled from implicitly guaranteed investments. In other words, investors fled to an equivalent of the FDIC. Simply put, you need government guarantees about losses to stop a run. Regulations and Capital Standards won't suffice. Well, they could, but they would be incredibly onerous and high, making them impractical, so, in effect, you need government guarantees to stop runs.

In the current crisis, it has all been about the extent and particulars of government guarantees. Certainly the gyrations of government actions have led to problems, but only in the sense of not making the extent of the guarantees explicit and particular. Anyone who believes that we could stop this crisis without government guarantees, like US Treasuries, is wrong.

From my analysis, it's clear that regulations and capital standards are not sufficient to stop a run. They might have effected this crisis in some manner, but explaining the crisis by seeing what has just occurred and writing laws that might have prevented it is of very little use, and has no real explanatory power. It's a help going forward, but, taken too particularly, it will result in a set of rules and laws that very smart people will manage to elude.

What to do then going forward?
1) Put in some sort of FDIC Insurance for these investments
2) Accept that runs might occur, and do your best to preclude them and be prepared for them
On 2, I say," good luck". Wishful Thinking at its worst. This is what will happen naturally.
On 1, what can we do? I suggest Bagehot's Principles. We need a LOLR I'm sorry to say in the modern world. All that we can do is make the guarantees explicit and adhere to firm standards going forward. But there is no practical solution without LOLR guarantees. They should be robust enough to preclude Calling Runs. One solution would allow some minimal use of FVA as opposed to MTM in supervised cases, with a government guarantee.

For libertarians, I'm sorry. This is the best that we can do for you. However, by averting Runs, we can avoid the kind's of crises that usher in enormous government intrusion. That should prove sufficient to the practically minded.

Finally, to the FDIC abstainers, a Burkean response. We don't have the FDIC for James Grant. We need it for:
1) Our actual Investor Class, which feeds on government guarantees and intervention.
2) Much more importantly, and let me put this in terms that the Investor Class can understand, in order to stave off social rebellion. A system that leads to mass unemployment, low wages, a very wealthy upper class, is not stable. Telling average workers to accept the pain of recessions and depressions is going to eventually lead to trouble. They don't have to. In other words, some people believe that we live in a world where such events as rebellions cannot occur. Of course, some people live in a world where depressions cannot occur. As a good Burkean, I know that isn't our world, and the bonds of civil society must allow compromise in order to stave off societal dislocations.

"I'm betting the theory of regulatory competition is going to go on holiday for a few years"

Justin Fox with a post about what I call Rationalization:

"The top West Coast regulator of the Office of Thrift Supervision has been removed from his jobwhile the Treasury Department's inspector general looks into some weirdness surrounding backdated capital infusions into since-failed thrift IndyMac( I POSTED ABOUT THIS STORY ). Add that to the demise of the biggest savings institution regulated by OTS, Washington Mutual, the loan troubles inherited from OTS-regulated Golden West Financial that forced Wachovia into a merger with Wells Fargo, and the various shenanigans associated with OTS-regulated Countrywide Financial, and things really aren't looking good for the agency. Oh, and don't forget AIG, which due to a quirk in our country's deeply quirky regulatory setup was also overseen at the holding company level by OTS( PLEASE. NO MORE ).

The OTS was created as a semi-autonomous division of the Treasury Department 1989, to take over the regulatory duties of the Federal Home Loan Bank Board, which was seen as identifying too closely with the savings and loan industry to do a good job of supervising it( YOU CAN'T BE SERIOUS ). I was the OTS beat writer for American Banker in the mid-1990s, and in those days the agency was trying hard to be professional and just as tough as the other banking regulators. But there was still lots of talk of looking out for the interests of the thrift industry, and ensuring the attractiveness of the federal savings bank charter that OTS oversaw( HOW CHUMMY ).

That's just the natural tendency of any specialized industry regulator, and I'm certainly not going to blame OTS for our current troubles ( I WILL GIVE THEM A TINY PORTION OF BLAME, IN THAT THEY ALLOWED REGULATORY SHOPPING ). The craziest of crazy mortgage lending was done by mortgage brokers selling to Wall Street. The OTS-regulated thrifts mostly just followed( THAT'S ENOUGH FOR BLAME ) in their lead. But OTS didn't stop them, I imagine, because people there were worried about thrifts losing market share( YES ). That, and they had been drinking the same home-prices-never-go-down Koolaid ( I DON'T BUY THIS KOOLAID ) as everyone else in real estate. The regulators were of the industry, not above it( NICE ).

This country's Balkanized financial regulatory structure (just for banks and savings institutions there's the OTS, the OCC, the FDIC, the Federal Reserve, and all the state banking commissioners) is mostly the product of history and bureaucratic turf wars. But for the past few decades there's also been a theory—regulatory competition, it's called—to back it up.

Having different state and federal entities compete for the privilege to regulate a particular company results in more market-friendly regulations, the thinking( THAT'S WHAT IT IS UNTIL THE REAL WORLD COMPLIES ) goes. That may be true, but more market-friendly regulations are also generally weaker regulations( TRUE ), and in the financial sector weak regulations can eventually end up destroying the very markets they're being friendly to. As we've seen lately( I AGREE. SOMETIMES, POORLY ENFORCED REGULATIONS ARE WORSE THAN BOTH ZERO REGULATIONS AND TOUGHER REGULATIONS ).

I'm betting the theory of regulatory competition is going to go on holiday for a few years, maybe decades. The OTS will be among the first victims of the new intellectual climate—Hank Paulson already proposed getting rid of it last spring. Any guesses as to who's next after that?"

I've already said that the whole system needs to be Rationalized. In other words, streamlined.

"He calls for a regulatory system based on “principles” rather than “rules.”

Via Deal Book on the NY Times we get "Stephen Schwarzman’s Seven-Step Program":

"In an opinion piece in The Wall Street Journal’s Nov. 4 issue, Mr. Schwarzman maps out seven principles he believes should guide any regulation of the financial system. In many of them, he uses the opportunity to criticize the current regulatory framework in the United States, describing a “hodgepodge” of fragmented agencies and laws that make a “fetish of compliance with complex regulations.” He expresses concern that the latest debacle on Wall Street will inspire a thicket of new rules that choke off innovation."

Here's my comment:

“He calls for a regulatory system based on “principles” rather than “rules.” He writes:

If we are to sweep a vast array of financial institutions into the net of a single regulator, then that regulator has to be able to regulate not by promulgating a blizzard of ever more complex rules, but by enunciating a set of guiding principles. If these principles are coupled with strong disclosure and oversight, they will give the regulator the flexibility needed to cope with an ever-changing financial landscape, and to provide a clear direction for the regulated institutions.”

I agree with this:

This is the real problem with regulation. These investors can be very clever people, and are adept at shifting the terrain. That’s why regulation always seems to be correcting the last problem.

The solution is either to regulate or supervise risk, especially any investment that shifts risk to a third party or magnifies risk. In other words, broad principles.

However, have you ever noticed that some of these recommendations being bandied about are as simple disclosure and transparency, traits one would think a decent human being would try and exemplify as a matter of course.

— Posted by Don the libertarian Democrat

The Path To Re-Regulation

Gross on regulation resulting from this crisis:

"In the meantime, a surge in regulation of the financial sector will be unleashed, probably an inevitable result of the problems and rescues of recent months.

“Twelve to 24 months down the road, all of these high-flying investment banks and banks will be reregulated and downsized,” Mr. Gross said. “They won’t become arms of the government, but they will be supervised and held on a tight leash.”

The greater regulation should draw investors back to the market and away from what seems to be their current financial strategy — stuffing their cash in mattresses."

One of the probable downsides of a crisis like this is the problem of over-regulation resulting, which is why I favor enough regulation to keep this kind of crisis from occurring. However, as even Gross admits, some regulation is necessary for investors to re-enter the market. Let's hope we strike a better balance this time.