Centralized Frameworks

The Obama administration has big plans, or at least big words for the financial industry. Though there has already been plenty of commentary on their new proposals and plenty of people weighing in with their own take on what a revamped financial system should look like, I feel obligated to opine as well. If what follows sounds overly theoretical and short on details, bear in mind that the 90 pages Treasury put out contains exactly one hard number, and an incorrect one at that (they suggest originators should be required to hold 5% of the value of a securitization on their books, which would be no more than symbolic). So the devil remains in the details. The debate is necessarily still very high level and still mainly a product of what you think caused the crisis, and what you think a healthy financial system actually looks like.

The clearest conclusion one reaches from reading the whitepaper is that the new financial system will be even more centralized in the hands of the Federal Reserve and the Treasury. They propose to have the Fed extend to the entire financial system regulation that till now has applied to the official banking system (ie. they propose to regulate the shadow banking system. They propose to create a new department within Treasury to oversee systemic, and not merely firm level, risk. They propose to have centralized Federal level regulation of banks, thrifts, hedge funds, investment banks, insurance, etc ... We can debate the merits and even the necessity of any of these particular steps -- most of them make pretty good intuitive sense and in general they are not terribly radical -- but the overall effect of these reforms will be to consolidate financial and regulatory power, and concentrate it the hands of very few people. Perhaps in an effort to minimize turf wars and lobbying pushback, the paper is written as a sort of political two-step that doesn't trumpet this fact, but it still comes through loud and clear.

Hence the predictable response of the WSJ op-ed types (and remember never to trust anything that comes out of the AEI):

Although the president said in his speech that he supports free markets, these initiatives confirm that the administration fears the "creative destruction" that free markets produce, preferring stability over innovation, competition and change.

According to the administration white paper circulated prior to the president's speech, the Federal Reserve would be authorized to create a special regulatory regime -- including requirements for capital, leverage and liquidity -- for any firm "whose combination of size, leverage, and interconnectedness could pose a threat to financial stability if it failed." In addition, if a large financial firm is failing, the Treasury is to be given the power -- in lieu of bankruptcy -- to appoint a conservator or receiver to "stabilize" it.

Designating particular financial firms for this kind of special regulatory treatment clearly signals to the markets that these institutions are too big to fail. It will reduce the perceived risk of lending to them, enabling them to raise funds at lower cost than their smaller competitors.

In other words, the administration's plan would create what are essentially government-sponsored enterprises like Fannie Mae and Freddie Mac in every sector of the financial economy -- insurers, securities firms, finance companies, bank holding companies, and hedge funds -- where these specially regulated firms are to be designated. The result will be devastating for competition. Larger firms will squeeze out smaller ones and aggressive small companies will have less opportunity to overcome the government-backed winners.

While predictable, I think there is something to this observation, though the final lines veer towards ideology and away from description. The administration is definitely opting for stabilization and regulation, not for radical change, and not for dismantling the largest firms who were at the center of the crisis. The effect will be to sanction some firms as too big to fail, a fact made apparent from their introduction of an entirely novel regulatory category, the "Tier 1 Financial Holding Company". However, it remains to be seen how draconian the regulations imposed on those firms actually are. One can imagine a situation where the too big to fail doctrine is effectively sanctioned, but the newly vindicated mega-firms are kept on such a tight leash that they become rather boring. One interesting passage in the whitepaper even states explicitly that the idea (at least) is to allow these firms to exist, but to force them to internalize the costs of protecting against their failure. You can do this with higher leverage ratios, more restrictive regulation, more taxes, etc ... At any rate, contrary to the leap of logic in the op-ed, it is theoretically possible to have a boring regulated monopoly type baking sector that is highly concentrated, but not overly profitable and hence relatively stable. Mr. AEI here romanticizes "creative destruction" and "financial innovation" per the party line, but the truth is that you probably don't really want either of those terms to apply to your core banks. A highly concentrated and tightly regulated but government protected financial sector is probably not the worst thing that could happen to the real economy ...

... for about 5 minutes ...

... because that is how long it will last.

This is the point in the debate that everyone misses. And I know why they always miss it too; people have the hardest time imagining how systems adapt. They always imagine that we can design even the most complex systems from the top down, figure out how we want them to look in their ideal state, put them in that state, and then expect them to stay there. In my opinion this is our fundamental problem in thinking about politics and economics. We design fragile monocultural solutions that depend on a shallow unstable equilibrium. No wonder the damn thing blows up every twenty years. We never confront the hard problem of designing something that is evolutionarily stable, something that has built-in defense mechanisms to protect against the most obvious threats. Or, at least, we haven't done this since we signed the Constitution.

Anyhow, the main problem with the new financial regulatory structure is being billed as a feature, not a bug. We will have something more centralized, more concentrated, more technocratic, and even more susceptible (after a suitable period of mourning of course) to the same disease we just witnessed. The op-ed thus gets to the point, and proceeds to miss it entirely. Yes, we will have a less competitive, more managed and 'socialist' financial system. But the real problem is not that this is inefficient or that it rewards failure instead of success (the op-ed goes on to make embarrassingly stupid statements about how the government model is to treat everyone like AIG and how it really wasn't that big a deal to let Lehman go under). The problem is that in the long run it is not even stable. If the only way to get ahead is to capture the one central regulatory body, if that is a sound business model, then you can be sure that someone will manage it.

I know I know, we all think we have learned our lesson, and we all believe that Obama is a great guy, an that the Fed is full of smart people and we all want to and need to trust our government -- but this is exactly the problem, it was trusting our government when it fell, quite predictably, into the hands of an idiot that got us here in the first place.

I might write some more on the details later. The ideas, in the short term, are actually pretty reasonable, though we lack the details, and much of the discretion is left up to the Fed and Treasury. Do you trust Geithner and Bernanke to fix everything, or do you think that they may find themselves an opening at Goldman Sachs when all this blows over? Yeah, that's what I thought, and that's the problem.