Financial [Re]Regulation

It is a sad commentary on the state of the economy that I return after a few days of idle bliss only to discover that the main topic of discussion is precisely the same as it was last week. And the week before that. And … well the banks need fixing. Not a lot of surprise there I imagine for anyone who had inhabited planet earth during the last two years.

At least the exact topic has shifted. Sort of.

Now we are being treated to a wave of speculation about the shape and timing of the big new regulatory effort that will wind its way through the halls of Congress later this year. For instance the Financial Times speculates that reform of the regulatory system is being slowed down so as to allow other items on the administration’s agenda to have some space or focus while the details of the regulatory legislation is hammered out behind closed doors.

The centerpiece of the new system, whenever we see it, is likely to be an authority roaming over the whole of what is called ‘systemic risk’.

“Our failure to take dynamic and strong action to recapitalize the big banks is having all sorts of ‘knock-on’ effects.”

If there is one thing we learned through this crisis it is that the risk management activities of the financial industry are inept at managing risk. Truly inept. So poor are the banks at risk management that, in their zeal to hedge, offload, mitigate and otherwise purge themselves of it, they magnified, concentrated and loaded up on it to a disastrous degree. They simply fooled themselves. They moved risk off balance sheet as if that shed it entirely. They bought contracts to protect themselves against default only to find that their counter-parties could not honor the contracts and therefore represented a risk themselves. They hedged positions using models that only work in utopia. And their ‘innovation’ of risk management products produced a veritable menagerie of Frankenstein like contraptions that ran amok trampling the balance sheets of those unfortunate enough to have fallen prey to what we have to call the ‘risk-avoidance-but-is-really-risk-concentration’ disease that infected Wall Street and all who came into contact with it.

Swine flu has nothing on this one.

Somewhere Mrs Shelley is smiling at the inventiveness of the lunatics who dreamt all this stuff up.

It takes a particularly fertile imagination to conceive that some of these wonderfully innovative products represent any value to anyone other than the people peddling them. They certainly turned out not to manage risk.

My view is that the entire derivatives trade ended up being a massive con game, the whole purpose of which was to allow a few folks to generate vast wealth for themselves. The con artists lived in an incestuous fraternity skipping from one employer to another, oblivious to the goals and needs of their current employer, and supporting one another through the execution of thoroughly useless trades.

Why else would someone take out an insurance policy against the risk of default of the US Government? In the realm of senseless transactions that one shines most brightly.

Its purpose?

None.

None, that is, economically.

Its motive?

Bonus. Someone had to make a trade to meet a bonus target.

So I suppose that some risk was being mitigated: the risk of traders not hitting their bonus targets was assuredly eliminated. That and the monthly profit targets of the legions of lawyers, accountants and hangers-on necessary to transact these insanely arcane pieces trash.

Thus we need ‘systemic’ regulation.

The entire system can be brought down by the tortuous nonsense these folks created. So we need to protect ourselves against the consequences of their snake oil.

The old regulatory system focused on single banks. It had a vertical quality to it. The theory was to manage to banks, each in isolation, by controlling their activities one at a time. So regulatory efforts took the form of audits and examinations testing the risk management methods of the banks. This left unattended the linkages between banks. The labyrinthine entanglement created by the booming trade in derivatives went uncontrolled because it cut across the system. Its risk characteristics are every different when viewed horizontally between banks rather than vertically within a single bank. The collapse of AIG and the threat it became to other banks is an example of this.

So systemic is in.

But that means big changes to our current regulatory set up so political infighting will inevitably slow down enactment of anything meaningful. All our regulators stand to lose jurisdictional territory. Obviously someone will win, but in the meantime the knives are out.

Simultaneously with this systemic risk management effort is the other big component of re-regulation: the establishment of the authority to take over and wind down large banks.

One of the reasons the administration has failed to fix the capital problems of the big banks is that is has been hesitant to seize them and force them through a government run reorganization. It perceives it does not have the legal authority to dissolve a bank holding company in the way current law allows it to seize smaller banks. This perception was one major cause driving the Treasury Department to step around bank capital issues rather than tackle them head on. The new resolution authority will need to be funded in the way that the FDIC is and that raises political problems: small banks are objecting to having to contribute to a fund that has no impact on them. I assume this will be resolved quickly, but it demonstrates the tip-toeing necessary to get new regulation in place. At the same time the big banks, who will have to ante up to pay for the new authority, don’t want to contribute right now either: they need to retain every penny of their profits so they can earn their way back to health.

Which brings me back to my ongoing thesis with respect to the banks:

Our failure to take dynamic and strong action to recapitalize the big banks is having all sorts of ‘knock-on’ effects. In this case it is slowing to a crawl our ability to set up a new regulatory structure. We need the banks to earn their way free of the crisis. This will take time. There is no certainty they will succeed – the rising tide of credit card and commercial real estate defaults could swamp their efforts to retain profits. Meanwhile we remain exposed to the lunacy of the old structure.

It is tiresome to have to keep repeating this: we have not fixed our banks. The stress tests were a sham. The capital targets too low. The entire banking system remains undercapitalized even after all the frenzy of post stress test share and bond sales.

The best we can say is that the banks are now able to limp slowly. They no longer are crawling on all fours.

So the result of hundreds of billions of taxpayer dollars and many months of dodging and weaving by two administrations is that we have a ‘merely’ crippled system rather than a ‘near dead’ one.

Progress of sorts.

But not enough.

Plus ca change.

Addendum:

I neglected to refer to the administration’s announced efforts to impose regulation on derivatives. Remember that derivatives were specifically exempt from regulatory oversight or control during the Clinton administration: the thinking was that leaving the derivatives market unregulated would allow innovation to flourish. This innovation was thought to lead, inevitably, to market driven solutions to risk management.

This blind faith in market driven problem solving works well in the nirvana that is neo-classical economic theory. It tends to flop in the real world where the vanities and idiosyncrasies of less than rational people muddy the waters a bit.

So the effort to put boundaries around the derivatives market and to make it open to scrutiny is a welcome step forward.

I would have preferred that all derivatives be traded in the open. But as seems to be the case with much of what this administration does, caution has prevailed and we get only partly open trading. Too many of the administration’s experts are beholden to the market-is-best world view. So the fallacy lingers on near the center of policy making and manifests itself in the half steps taken instead of the whole steps that were available.

Sigh.