Strict borrowing rules and the like worked after the Depression; similar regulations could work now.
More than a year after the financial industry nearly collapsed, Congress and President Obama are taking up regulatory fixes. But their strategy is a blueprint for the next catastrophe.
The centerpiece of the financial reform bill that the House passed this month, following Obamas blueprint, is a new Financial Services Oversight Council. It is based on the premise that the credit crisis came about because no single agency had the job of overseeing the whole financial system. Instead, each agency was responsible for its own little piece of the elephant.
The new regulator would seek to remedy this perceived deficiency, identifying and neutralizing potentially grave risks to the financial system before they turn into disasters. Under the House version of the bill, the regulator would have the power to force a “too big to fail” bank to sell its riskiest divisions to reduce the danger it posed to the economy, and would have the power to mandate stricter borrowing rules and the like for supposedly riskier banks. As a spokeswoman for Senate Banking Committee Chairman Christopher J. Dodd said last month, “We need a system that predicts and prevents the next crisis.”
But such an “omniscient” regulator could not have prevented our current crisis. Five years ago, such a regulator likely would have declared triple-A-rated mortgage-related securities safe, allowing financial firms to borrow more liberally against them than they could against seemingly riskier securities. The bankrupting losses that eventually occurred from such borrowing seemed impossible back then. The next global crisis could be a crisis of government debt -- although government officials around the world have decreed their own debt to be the safest investment imaginable for regulatory purposes.
It should not be the job of regulators to assess risk from the top down. Congress should instead follow the regulatory philosophy that served the nation well for 50 years after the Depression: Set consistent limits on borrowing across similar financial instruments, no matter what their perceived risks.
It should do the same for financial firms, whether they call themselves banks or something else. Then, financial firms can assess risk from the bottom up, and the economy will be better protected if their assessments turn out wrong.
Clear borrowing limits are necessary because sometimes nobody sees any risk at all. Before the Depression, for example, speculators could borrow on a nearly unlimited basis to purchase stock. The idea that stocks could fall precipitously en masse seemed inconceivable at the time. When the stock market and other debt-dependent markets did go bust, they left behind massive unpaid debt that severely weakened banks and worsened the Depression.
To guard against a repeat, President Franklin Roosevelt and policymakers imposed uniform borrowing limits to protect the economy from financial firms inevitable mistakes in picking stocks. They didnt create a “stock securities oversight council” to determine which stocks were safe and which werent. Investors were free to lose money, but they werent free to build up so much debt that their unpreventable human errors would destroy the economy. Policymakers also required that stock exchanges and companies disclose their activities regularly, so that investors could learn, if they wished, of the risks that they were taking.
Over the last two decades, Washington stopped extending these old principles to new markets -- and the crisis we got is the natural result of that erosion.
In 2000, for example, the Federal Reserve counseled Congress to prohibit borrowing limits and requirements to disclose trading activity on some new financial instruments, including credit-default swaps. Regulators believed that they, and financial industry executives, had already done what todays proposed systemic risk regulator would do: identify and erase the potential for error.
What if regulators had instead allowed innovation to flourish within some reasonable rules? AIG, for example, would have had to put a consistent cash percentage down behind the $500 billion in promises -- a form of borrowing -- that it made through credit-default swaps. And it would have had to execute those promises on public exchanges, making them transparent.
AIG might have gone under anyway -- failure is a healthy part of capitalism -- but it would not have threatened to take the economy with it, necessitating a government bailout that set a dangerous precedent. Indeed, in 1995, a British investment house, Barings, was allowed to go bankrupt without a bailout. The firm had largely made its bad derivatives bets on regulated markets, a crucial difference between it and AIG.
Borrowing limits in the housing market would have protected the economy too. As the bubble expanded, people would not have been able to keep up with a requirement for, say, a consistent 20% down payment, thus dampening demand. And when the bubble burst, it would not have left behind so much unpaid debt.
Consistent borrowing limits eliminate the need for a vast bureaucracy to micromanage the financial system -- a bureaucracy that could be captured by powerful companies. Such limits would also help solve the too-big-to-fail problem.
Big commercial and investment banks now enjoy an unfair subsidy: the expectation of future bailouts. These firms know that as long as the economy remains unacceptably vulnerable to their mistakes, the government will not let them fail. With lenders protected from losses, Wall Street firms can borrow more, and more cheaply, than they should.
If, instead, the government better protects the economy from Wall Streets failures, then Wall Street lenders will understand that taxpayers wont be there to rescue them anymore.
We cant prevent failure -- and shouldnt. We can, however, better insulate the economy from its damaging effects.
Original Source: http://www.latimes.com/news/opinion/commentary/la-oe-gelinas25-2009dec25,0,2169729.story