Friday, December 4, 2009

Hey, wasn't that equilibrium we just passed?

Unsurprisingly, very smart Harvard profs suggest that we need nothing more than a technical fix for financial regulation to get us moving on towards the next bubble.

The harder question is how to limit inordinate risk-taking by the protected financial firms, especially given the difficulties in evaluating the risk in their portfolios. Ideally, bigger firms that enjoy some sort of public guarantee should pay a "public insurance premium,'' which would be a function of capital levels and risk. 
But the daunting problem in either charging such a premium, or enforcing plain old capital requirements, is measuring risk-weighted assets.

So don't risk weight the fucking assets.  This was always a practice that lent itself to regulatory arbitrage, and the definition of risk as recent volatility leaves, ahem, something to be desired.  People always tell you that, "yes, we're highly leveraged, technically, but you have to differentiate between leverage and risk". Bullshit.  Leverage IS risk.  Volatility comes and goes, but bankruptcy is forever.

One way for regulators to better evaluate financial risk is to borrow a trick from the income tax system. Our incomes are reported more or less correctly because employers have a strong incentive to state our earnings. Since stating our full income reduces their tax liability, firms rarely help hide their workers' incomes. Employers and employees that report different numbers are raising a giant red flag.

Banking regulation can use the same rat-on-your-partner structure. Every credit default swap involves two parties - one taking on more risk and one shedding risk. The regulatory system should treat this as a transfer of risk where the insurer is taking on exactly as much danger as the insured party is shedding. If each firm's public insurance payments or capital requirements depend on their risk, then the insured entity has an incentive to accurately report the risk the insurer is taking on. With the right system, every firm has an incentive to report on each other and to make sure their numbers match.

Having the banks rat on each other sounds great until you realize that:
  1. there are only a few big ones now, and they could collude pretty easily
  2. your measure of risk is useless to begin with.  The banks could each run to the Fed screaming about how little Cathy stuck her hand in the cookie jar, while they meanwhile ignore and even encourage Testosterone fueled Tommy in the basement with his shiny new nuclear weapons playtime kit.
All this brings up another question.  Lots of clever people have come up with lots of clever ideas about how to improve the rules the financial system is forced to play by.  These solutions are typically designed to involve the smallest of regulatory tweaks to our existing structure.  The claim is that this approach is more "pro-market" and preserves the incentives for "financial innovation".  The obvious flaw is the reasoning is that these people begin with the mistaken assumption that we have a market, and that we have financial innovation worth preserving.  We clearly have neither.  Markets allow firms to fail when they flounder.  Innovation provides for new services (such as banking for the 25% of Americans who don't regularly use a bank) which tends to be disruptive and causes some firms to fail and others to succeed. 

Real pro-market (rather than pro-business) solutions don't try to dot an imaginary i in an effort to preserve a non-existent market.  Real pro-market reforms start with the realization that the market for rules -- financially, politically, and ideologically -- has already been cornered.

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