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Monday, November 2, 2009

More Regulation or Different Regulation?

Anti-regulation folks are continually pointing out that intervention in business affairs is unwise. It seems they ignore the fact that, often, the reasons for bizarre market behavior [that disrupts "normal" market mechanisms and exposes everyone, even non-participants, to great financial risk] are the specific terms under which a business sector operates, i.e. the man-made rules that constrain [or don't] what economic actors can do. The government can foster more order and create rules that promote stability in the economy – a situation that most folks would desire. For instance, the government should regulate credit default swaps just like insurance, because that is what it is. Playing games with the names of financial products is also blatantly misleading. The “equity tranches” of mortgage-backed securities turned out to be the most risky, and most holders have experienced huge capital losses – though the word “equity” implies less risk. For those with perseverance, patience, and an appreciation of complex mechanisms see this SEC report:

Certain regs seem like no-brainers:

For instance, rating agencies: This function of assessing and broadcasting the creditworthiness of firms is very sensitive, and has large impacts on who gets money, and what is invested in. If they are doing a poor job, maybe their methods or approach can be improved. Is this an area that should be regulated? How much? Credit Default Swaps should be addressed at the same time - much more transparency is needed.

For instance, banks: the environment in which they manage assets is set up with many options for how, and in what, to invest. Each approach may have highly technical terms and mechanisms that are used to manage the risk of the contracts or limit their scope, or other purposes. These technical complexities can open the doors to bizarre incentives when conditions not previously anticipated occur. Yes, they are already regulated. How much is enough? Does regulation only need to be strongly prescriptive in the high-risk areas? "Normal" bank operations, before the emergence of investment banks of gargantuan proportions and the blurring of the lines between the two, saw "crises", but each was more contained and recoverable from [ In the 1980's, the S&L “crisis” was a dry run for the recent crash – a much smaller housing bubble ]. Some say that highly targeted regulation is required, not regulation which is a ball and chain on every participant in the economy. That approach seems short-sighted in that we it's rather like the dutchman's finger in the dike - we plug up the holes we see, but more will spring up. Rather than encumber our system with more layers of regulators, and more rules for them to try to enforce, simpler measures – limiting bank size, raising reserve margins, and requiring reasonable proof that a loan will perform as everyone expects before approval - should be considered.

For instance: dangerous overuse of leverage, packaging of debt instruments undermining confidence in the system. See last paragraph.

Finance businesses create opportunities for get-rich schemes that allow individuals to aggregate money, make a short-term profit, then get out [essentially, legal Ponzi schemes enabled by misinformation, mis-valuation, misrepresentation, mis-etc.]. Should the institution responsible for maintaining property rights get involved and mediate between parties when disputes occur? Of course they should. Are the courts sufficient to the task? That's debatable. If there is an ongoing problem with an aspect of the business system that keep recurring in the courts, perhaps the court is not the right venue to resolve these conflicts.

So we could have legislation to correct these defects. There are several drawbacks to that. Sometimes the changes required are highly technical. Sometimes they are very narrow and poorly understood, except by insiders. The number of instances requiring intervention/adjudication is quite large, and it is difficult to cover many perceived problems with simple changes. Legislators cannot micromanage, even if they wished to, due to the volume of complaints, and lack of consensus on solutions [especially among those who don't fully understand the issues - mostly not "insiders"; this makes the move from industry to regulator seem not so dumb - they know where the bodies are if they can be convinced to use a shovel!]. So our mechanisms for dealing with property rights issues create a need for regulation. Neither judicial or legislative intervention seems appropriate for some issues.

Essentially the entire body of western law derives from protection of property rights. Those who would have less government would also have more social friction due to less clarity over what an individual can do without being considered to be an infringement on his neighbor.

Some speak of regulation as if it were against "nature", whereas what it is against is the sometime inequity, unreasonableness, and occasionally just plain stupidity of the body of evolved man-made rules governing property rights. No offense intended to anyone involved in the evolution of these rules, but, as in nature, evolution can produce some pretty bizarre creatures!

Unintended effects and consequences are encountered regularly in most lines of business. When the risks are embodied in exotic financial instruments that only the Einsteins of finance seem to understand, we cannot allow huge institutions to use these financial instruments to gamble with a large portion of the wealth of the citizens of the U.S.

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