Financial Reform: Five Reasons Why We're Screwed

This past week brought a spate of articles on the woes of financial regulation. John Kay writes that the regulation we are getting “is at once extensive and intrusive, yet ineffective and largely captured by financial sector interests.” James Kwak thinks that crude capture at the level of Congress is exacerbated by intellectual capture at the level of regulatory staff. John Gapper sees a slightly different form of intellectual capture in which “any oversight that is biased towards preserving stability will often shy away from making life too difficult for banks.”  Randal Wray sees outright fraud—a system in which top corporate managers run their institutions as weapons to loot shareholders and customers for their own benefit. Although some of these writers use more measured language than others, all of them seem to agree with Wray on one point: We’re screwed.

So, can financial regulation be fixed, or not? Each writer points out reasons why effective financial regulation may be impossible, and I would add one more. As I see it, one of the biggest problems is that too many regulations, even those that are not tainted by capture, are prohibitions of specific risky activities, such as ownership of hedge funds or proprietary trading. This approach has two kinds of unintended consequences.

One is that prohibiting specific kinds of risks increases the incentives for fraudulently hiding them from investors, shareholders, and regulators. The other stems from the fact that financial institutions have an infinite menu of risky activities to choose from. If regulations prohibit some of them without curbing their inherent appetite for risk, they just move on to the next activity on their menu. Unfortunately, that activity may have a risk-return profile that is inferior both from financial managers’ own point of view and from that of the public interest.

It is like a parent who tries to get an obese child to take some weight off by saying, “No more chocolate ice cream, no more Big Macs.” The child just switches to mint chip ice cream and pizza.

In an earlier post, I used this diagram to illustrate the point. Regulators and bankers have different preferences so they seek different optimal points along the risk-return frontier. Ideally, regulators would like to find a way to induce banks to slide down and to the left along the frontier to a less risky point. Instead, by outlawing the specific strategies banks have used in the past, all they do is to drive them inward, away from the frontier and toward some new set of still risky but less efficient strategies. Both sides end up worse off.

The implication is that only two kinds of regulations could ever do any real good. One would be those that curb the risk appetite directly, for example, by changing compensation practices, by exposing financial executives to personal legal risks, or by other reforms of corporate governance. The other would be to break up institutions into small enough units that their failure can be tolerated. Of course, crude capture might make that kind of reform exactly the hardest to achieve. If so, then we really are screwed.

This post originally appeared in the "What's On Your Mind" department of Economonitor.com