Rodrik on Financial Regulation

Now that the credit markets for the moment have been moved out of intensive care, some commentators have shifted their attention away from “what should the powers that be do to prevent a meltdown” to the broader question of “what can we do to prevent this sort of mess from happening again?”

Dani Rodrik, in “Financial innovation: a case of aspirin or amphetamines?” via Project Syndicate, decides to categorize the solutions offered so far: the libertarian, which he dismisses, finance enthusiasts, who prefer a light hand and self-regulation whenever possible, and finance skeptics who want powerful regulators with a broad range of tools at their disposal. Rodrik observes that the degree of regulation needed depends on one’s view of the net gains from financial innovation.

Although this is a complex problem, let me single out two elements that may help focus discussion. First is that we have a highly integrated financial system that grew up on its own. That is big problem. It’s like having an electrical grid with no map of the network, none of the usual redundancies, shunts and switches built in. Because so many parts are OTC, cross international boundaries, and also feature unregulated entities as important players, no one has a model of the system. This is a considerable handicap in figuring out what to do.

This makes the Fed’s panic about Bear a bit more defensible. As with the minor electrical failure that brought down much of the East Coast in 2004, the authorities have no idea how great the damage would be if a major or medium sized player went down, but they have cause to think it could be bad, and the industry has every reason to fan those fears.

But (extending the grid metaphor) a second problem is not acknowledged: the securitization mechanism has broken down, due to a combination of lack of faith in the product and a reduction in sources for credit enhancement, which is essential for many of the products (as discussed elsewhere, that is why the GSEs, with their implicit Federal guarantee, are being asked to step up their activities. De facto, we have Federal credit enhancement in place of diminished private capacity). It’s if the transmission lines aren’t working because low temperatures have reduced conductivity. Everyone’s hoping the mini Ice Age will be over soon, but there’s no assurance that it will.

But we’ve learned the hard way that securitization and the absence of predatory lending rules is an explosive combination. The end investors don’t have the means to do detailed due diligence on securitized credits (management fees on bonds won’t support that level of expenses). The parties in the food chain have rejected an elegant solution, assignee liability, which would make the packagers liable for the any subprime deal that was “mis-sold.”

But if you aren’t going to make the critical players in the food chain liable somehow, the bad incentives and potential for abuse remains. And the name of the game this credit cycle has been to create as much product as possible, which meant leaning heavily on those with the greatest propensity to go into debt, such as the economically marginal and the optimistic (one might say imprudent). So the other way to go about reviving securitization would be either to toughen up predatory lending laws considerably or restrict the credit quality the assets that can be securitized. The industry will howl about how the poor will be hurt by restricted access to credit, which is not the real issue (it’s their loss of income), but a system that encourages people to get into what is many cases is an escalating debt habit is hardly a benefit either individually or for society as a whole.

From Project Syndicate:

The sub-prime mortgage crisis has demonstrated once again how hard it is to tame finance, an industry that is both the lifeline of modern economies and their gravest threat. While this is not news to emerging markets, which have experienced many financial crises in the last quarter-century, a half-century of financial stability lulled advanced economies into complacency.

That stability reflected a simple quid pro quo: regulation in exchange for freedom to operate. Governments brought commercial banks under prudential regulation in exchange for public provision of deposit insurance and lender-of-last-resort functions. Equity markets were subjected to disclosure and transparency requirements.

But financial deregulation in the 1980s ushered us into uncharted territory. Deregulation promised to spawn financial innovations that would enhance access to credit, enable greater portfolio diversification, and allocate risk to those most able to bear it. Supervision and regulation would stand in the way, liberalizers argued, and governments could not possibly keep up with the changes.

What a difference today’s crisis has made. We now realize even the most sophisticated market players were clueless about the new financial instruments that emerged, and no one now doubts that the financial industry needs an overhaul.

But what, exactly, needs to be done? Economists who focus on such issues tend to fall into three groups.

First are the libertarians, for whom anything that comes between two consenting adults is akin to a crime. If you are selling a piece of paper that I want to buy, it is my responsibility to know what I am buying and be aware of any possible adverse consequences. If my purchase harms me, I have nobody to blame but myself. I cannot plead for a government bailout.

Non-libertarians recognize the fatal flaw in this argument: Financial blow-ups entail what economists call a “systemic risk” – everyone pays a price. As the rescue of Bear Stearns shows, the government may need to bail out private institutions to prevent a panic that would lead to worse consequences elsewhere. Thus, many financial institutions, especially the largest, operate with an implicit government guarantee. This justifies government regulation of lending and investment practices.

For this reason, economists in both the second and third groups – call them finance enthusiasts and finance skeptics – are more interventionist. But the extent of intervention they condone differs, reflecting their different views concerning how dysfunctional the prevailing approach to supervision and prudential regulation is.

Finance enthusiasts tend to view every crisis as a learning opportunity. While prudential regulation and supervision can never be perfect, extending such oversight to hedge funds and other unregulated institutions can still moderate the downsides. If things get too complicated for regulators, the job can always be turned over to the private sector, by relying on rating agencies and financial firms’ own risk models. The gains from financial innovation are too large for more heavy-handed intervention.

Finance skeptics disagree. They are less convinced that recent financial innovation has created large gains (except for the finance industry itself), and they doubt that prudential regulation can ever be sufficiently effective. True prudence requires that regulators avail themselves of a broader set of policy instruments, including quantitative ceilings, transaction taxes, restrictions on securitization, prohibitions, or other direct inhibitions on financial transactions – all of which are anathema to most financial market participants.

To grasp the rationale for a more broad-based approach to financial regulation, consider three other regulated industries: drugs, tobacco, and firearms. In each, we attempt to balance personal benefits and individuals’ freedom to do as they please against the risks generated for society and themselves.

One strategy is to target the behavior that causes the problems and to rely on self-policing. In essence, this is the approach advocated by finance enthusiasts: Set the behavioral parameters and let financial intermediaries operate freely otherwise.

But our regulations go considerably further in all three areas. We restrict access to most drugs, impose heavy taxes and marketing constraints on tobacco, and control gun circulation and ownership. There is a simple prudential principle at work here: Because our ability to monitor and regulate behavior is necessarily imperfect, we need to rely on a broader set of interventions.

In effect, finance enthusiasts are like America’s gun advocates who argue that “guns don’t kill people; people kill people.” The implication is clear: Punish only people who use guns to commit crimes, but do not penalize others by restricting their access to guns. But, because we cannot be certain that the threat of punishment deters all crime, or that all criminals are caught, our ability to induce gun owners to behave responsibly is limited.

As a result, most advanced societies impose direct controls on gun ownership. Likewise, finance skeptics believe that our ability to prevent excessive risk-taking in financial markets is equally limited.

Whether one agrees with the enthusiasts or the skeptics depends on one’s views about the net benefits of financial innovation. Returning to the example of drugs, the question is whether one believes that financial innovation is like aspirin, which generates huge benefits at low risk, or methamphetamine, which stimulates euphoria, followed by a dangerous crash.

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  1. Anonymous

    Libertarians and financial enthusiasts assert financial innovation over the past 20 years or so has been a boon to the economy.

    Where is the proof of this assertion?

    We need to insist on proof — or, in its absence, retort loud, clear and with empirical evidence, that the assertion is as baseless a piece of ideological PR as every other effort by the right wing whose only interest is winning and lining their own pockets.

    Financial innovation, as actually practiced, went well beyond the Minsky moment. Does that make all financial innovation bad? No. But, the only financial innovations that accrue to the whole economy’s benefit would be those that don’t reach Minsky moments.

    How to achieve that?

    Only with regulation.

  2. JWhitland

    To correct a bad metaphor–It’s as if the transmission lines aren’t working because HIGH temperatures have reduced conductivity. Heat decreases conductivity.

  3. Anonymous

    “We now realize even the most sophisticated market players were clueless about the new financial instruments that emerged……”

    Bullshit. The industry knew exactly what they were doing, just like they know now. This statement is the big lie that will impede the progress of regulatory enforcement that is so desperately needed.

    The Fed, in it’s herculean effort to save the system, is ensuring it will continue. Had they simply utilized the tools at hand several years ago, the markets would not be in the mess.

    The Federal Government, at the behest of the industry, invoked a 19th century law to stop the states’ attorney generals from regulating predatory lending practices. Any suggestion that the financial corruption was an accident is laughable.

    The executive branch is responsible for enforcing the laws of the land. There are plenty of regulatory tools in place to stop the predatory financial industry in its tracks.

  4. Mencius Moldbug

    The problem is not “innovation.” The problem is maturity mismatching. Require all financial players to run books that are balanced not just by scalar present value, but by maturity, and the whole freakin’ liquidity problem goes away.

    I find it rather interesting that those who are so gung-ho on regulation in general become so dogmatically libertarian on this one little point…

  5. Mencius Moldbug

    Also: if readjusting liability post facto (effectively, rewriting the terms of a contract after it has been signed) is “elegant,” I’d really really hate to think of what “ugly” might amount to.

  6. Yves Smith


    No one, including this blogger, has suggested that assignee liability be made retrospective.

  7. Mencius Moldbug


    You’re right – you didn’t.

    I interpreted the phrase “make the packagers liable for any subprime deal that was mis-sold” as a reference to events in the past. Reading the post behind the link, I see that you actually meant “make future packagers liable for any subprime deal that they mis-sell.” I apologize for the confusion.

    However, I still doubt that any further entanglement between the litigation and financial industries would be a net positive, except of course for the former.

    A broad property of today’s judicial system is that it wildly exaggerates its power to produce fair and predictable outcomes. For example, the above sentence requires two definitions to achieve any kind of precision: “subprime” and “mis-sell.” Imagine constructing a robust, precise definition of these terms. For the second, you have essentially required your judicial system to produce a definition of the word “bad.” It is certainly capable of trying.

    One way to think about judiciability is to imagine a prediction market for judicial decisions. A problem is judiciable if the market’s forecasts are (a) reliable, and (b) based on the details of the case, not the identity or predilections of the judge.

    If you abuse the judiciary system by applying it to nonjudiciable problems, you have created either (a) a regime of arbitrary and extortive coin-toss barratry, or (b) another great way for empowered interests to dine on their weaker enemies. I’d like to think that, as a liberal, you consider neither of these desirable outcomes.

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