The financial crisis: more transparency, less regulation
2 December 2008
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27 November 2008
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3 December 2008
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11 November 2024
The gut reaction to the current financial crisis is that we need more and better regulation. Few understand that regulation is part of the problem and not its solution. The solution lies in identifying its fundamental causes, which may be found in the traditional policy of organised obscurity in the provision of information on financial institutions.
Because financial institutions report to their regulators instead of the public, investors are left in the dark and cannot make informed judgments of market value. Therefore, when one bank gets into trouble the public does not know whether the problem concerns that bank alone or the banking system as a whole.
To play safe, the public begins to withdraw money from the banking system. In this way a solvency crisis turns into a liquidity crisis and a relatively minor drama in the US housing market turned into a major international financial crisis.
Suppose banks and other financial corporations reported directly to the public instead of to their regulators. The public including the banks themselves would then be able to distinguish between good and bad banks. Moreover, the onus of transparency would induce managements of financial corporations to behave more cautiously.
Currently, these managements take bad risks precisely because they know that the public will not find out. They have to inform their regulators, but regulators have a vested interest in allowing matters to degenerate into crises.
Regulation gives regulators power and importance. During a crisis they occupy centre-stage and become the would-be saviours of the world. The banks and other financial corporations understand this. They know that their regulators will bail them out, so they take risks which they would never have taken in the absence of state regulation.
It is no coincidence that regulated banks have been failing while unregulated off-shore banks have been safe. Unregulated banks have to fend for themselves by not skimping on capital and by avoiding financial adventures. They play safe precisely because they are regulated by markets rather than by regulators. The regulatory paradigm has failed. The time has come to replace it with an information paradigm that emphasises transparency, acknowledges the human weakness of regulators, and recognises the ability of markets to regulate themselves.
Because financial institutions report to their regulators instead of the public, investors are left in the dark and cannot make informed judgments of market value. Therefore, when one bank gets into trouble the public does not know whether the problem concerns that bank alone or the banking system as a whole.
To play safe, the public begins to withdraw money from the banking system. In this way a solvency crisis turns into a liquidity crisis and a relatively minor drama in the US housing market turned into a major international financial crisis.
Suppose banks and other financial corporations reported directly to the public instead of to their regulators. The public including the banks themselves would then be able to distinguish between good and bad banks. Moreover, the onus of transparency would induce managements of financial corporations to behave more cautiously.
Currently, these managements take bad risks precisely because they know that the public will not find out. They have to inform their regulators, but regulators have a vested interest in allowing matters to degenerate into crises.
Regulation gives regulators power and importance. During a crisis they occupy centre-stage and become the would-be saviours of the world. The banks and other financial corporations understand this. They know that their regulators will bail them out, so they take risks which they would never have taken in the absence of state regulation.
It is no coincidence that regulated banks have been failing while unregulated off-shore banks have been safe. Unregulated banks have to fend for themselves by not skimping on capital and by avoiding financial adventures. They play safe precisely because they are regulated by markets rather than by regulators. The regulatory paradigm has failed. The time has come to replace it with an information paradigm that emphasises transparency, acknowledges the human weakness of regulators, and recognises the ability of markets to regulate themselves.
22 thoughts on “The financial crisis: more transparency, less regulation”
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And so say all of us! The 1870 Insurance Act required life insurance companies to publish some limited information to the market and publish the basis on which it was calculated. The focus was the market and not the regulator. There was almost no expertise within the regulator and the regulator could send (and publish) letters to the company if it was unhappy – and that was all. In 75 years of operation there were about two insolvencies – neither of which affected policyholders greatly.
And so say all of us! The 1870 Insurance Act required life insurance companies to publish some limited information to the market and publish the basis on which it was calculated. The focus was the market and not the regulator. There was almost no expertise within the regulator and the regulator could send (and publish) letters to the company if it was unhappy – and that was all. In 75 years of operation there were about two insolvencies – neither of which affected policyholders greatly.
Exactly. Regulation is nonsense, but a bit of sensible banking supervision wouldn’t go amiss. Anybody with any knowledge of this would have known that Northern Rock was going off the rails at least two years before it actually went *pop* (click link above for explanation).
Exactly. Regulation is nonsense, but a bit of sensible banking supervision wouldn’t go amiss. Anybody with any knowledge of this would have known that Northern Rock was going off the rails at least two years before it actually went *pop* (click link above for explanation).
Well said. I would like you to recall all the financial crisis during the last decade starting from Thailand when Bangkok Bank went bancrupt and then caused went to linked S.Korea, Singapore, Japan etc. Experience shows that investing to mortgage loans is unsafe. At the same time, this tool was implemented to allow middle man to get a house. So, ironically if (globally) we still want a house for working person, we need global regulation to be set – and ruled! Circumstances changed.
Well said. I would like you to recall all the financial crisis during the last decade starting from Thailand when Bangkok Bank went bancrupt and then caused went to linked S.Korea, Singapore, Japan etc. Experience shows that investing to mortgage loans is unsafe. At the same time, this tool was implemented to allow middle man to get a house. So, ironically if (globally) we still want a house for working person, we need global regulation to be set – and ruled! Circumstances changed.
The arguments for greater transparency in the banking sector are persuasive, especially as a way to alleviate the crisis of depositor and investor confidence.
Furthermore, the provision of a central clearing house for the CDS market is one sensible way of increasing transparency in the markets.
I do have some significant disagreements with the other propositions in this article however and, due to the constraints on space, will post my criticisms in successive posts.
The arguments for greater transparency in the banking sector are persuasive, especially as a way to alleviate the crisis of depositor and investor confidence.
Furthermore, the provision of a central clearing house for the CDS market is one sensible way of increasing transparency in the markets.
I do have some significant disagreements with the other propositions in this article however and, due to the constraints on space, will post my criticisms in successive posts.
“regulators have a vested interest in allowing matters to degenerate into crises”
Although cynicism is not always unfounded this argument ignores the fact that the emergence of a crisis reflects badly on the regulator itself (see: John McCain’s knee-jerk insistence on firing the SEC Chairman Christopher Cox during the US Presidential campaign).
This is analogous to suggesting that the Department of Defence is purposefully negligent in defending the United States of America because it enjoys the prestige and funding associated with fighting multiple wars; a far-fetched argument to say the least.
This also ignores the fact that the SEC has been chronically underfunded for some years, perhaps a more salient reason for the ‘failures’ of financial regulation and oversight.
“regulators have a vested interest in allowing matters to degenerate into crises”
Although cynicism is not always unfounded this argument ignores the fact that the emergence of a crisis reflects badly on the regulator itself (see: John McCain’s knee-jerk insistence on firing the SEC Chairman Christopher Cox during the US Presidential campaign).
This is analogous to suggesting that the Department of Defence is purposefully negligent in defending the United States of America because it enjoys the prestige and funding associated with fighting multiple wars; a far-fetched argument to say the least.
This also ignores the fact that the SEC has been chronically underfunded for some years, perhaps a more salient reason for the ‘failures’ of financial regulation and oversight.
“Currently, these managements take bad risks precisely because they know that the public will not find out. “They have to inform their regulators…”
Unfortunately, they don’t have to inform their regulators. The main culprits behind the extensive exposure to sub-prime assets were the ‘shadow’ banking sector. Not the Moral Hazard beleaguered GSEs but the large investment banks such as Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns.
http://krugman.blogs.nytimes.com/2008/11/17/fannie-freddie-data/
Once more, Cox (SEC Chair) complained about the fact that the SEC could not force large investment banks to report their capital, maintain liquidity or submit to leverage requirements. He even asked for statutory authority to regulate investment bank holding companies before Congress this year.
“Currently, these managements take bad risks precisely because they know that the public will not find out. “They have to inform their regulators…”
Unfortunately, they don’t have to inform their regulators. The main culprits behind the extensive exposure to sub-prime assets were the ‘shadow’ banking sector. Not the Moral Hazard beleaguered GSEs but the large investment banks such as Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns.
http://krugman.blogs.nytimes.com/2008/11/17/fannie-freddie-data/
Once more, Cox (SEC Chair) complained about the fact that the SEC could not force large investment banks to report their capital, maintain liquidity or submit to leverage requirements. He even asked for statutory authority to regulate investment bank holding companies before Congress this year.
There are even some parallels with the crash of 1929 where the Federal Reserve was powerless to stem the flow of corporate funds into call loans, because its remit only extended to the traditional banks.
The SEC was also never given the authority to regulate the CDS market which has now ballooned to $60 trillion and intensified the initial consequences of the sub-prime meltdown.
It is difficult to square this fact with the suggestion that the ‘regulated’ banking sector was responsible.
“The banks and other financial corporations…know that their regulators will bail them out, so they take risks which they would never have taken in the absence of state regulation.”
No one would deny that the problems of Moral Hazard permeate the banking industry. However, maybe this has less to do with the existence of banking regulators and more with the fact that the banking sector as a whole, and particular banking institutions, have become ‘too big to fail’.
There are even some parallels with the crash of 1929 where the Federal Reserve was powerless to stem the flow of corporate funds into call loans, because its remit only extended to the traditional banks.
The SEC was also never given the authority to regulate the CDS market which has now ballooned to $60 trillion and intensified the initial consequences of the sub-prime meltdown.
It is difficult to square this fact with the suggestion that the ‘regulated’ banking sector was responsible.
“The banks and other financial corporations…know that their regulators will bail them out, so they take risks which they would never have taken in the absence of state regulation.”
No one would deny that the problems of Moral Hazard permeate the banking industry. However, maybe this has less to do with the existence of banking regulators and more with the fact that the banking sector as a whole, and particular banking institutions, have become ‘too big to fail’.
In such a situation, although greater transparency remains important, the existence of a regulator is surely warranted.
(I would suggest that more comment space be provided in order to allow for a fuller debate on the merits of each case)
In such a situation, although greater transparency remains important, the existence of a regulator is surely warranted.
(I would suggest that more comment space be provided in order to allow for a fuller debate on the merits of each case)