Chris Dodd's Financial Reform Bill Is A Road Map Leading Directly Into The Next Crisis

We still think Senator Chris Dodd still means well.

He genuinely seems to want to reduce the risk posed to the country from the financial system.

Unfortunately, his strategy for accomplishing this aim is very badly flawed. He wants to reduce systemic risk but his approach would actually increase systemic risk.

In the legislation Dodd proposed yesterday, the Federal Reserve would be allowed to order one of the companies it oversees to reduce the risks it takes. In the abstract, this sounds like something we need very badly. In the run-up to our last financial crisis, banks and other financial institutions took on way too much risk. If we’re going to avoid another financial crisis, it would be nice to be able to reign in this risk taking.

The problem arises because there’s no mechanism for bureaucratically identifying risk, the regulatory identification of risk creates its own systemic risk, and the temptation to politicize risk will be overwhelming. Let’s go through these one at a time.


How Chris Dodd’s bill will undermine the financial system.>>

The Fed Cannot Identify Risk.

Why would anyone want to put the Fed in charge of identifying risks at large, complex financial institutions?

The Federal Reserve has a terrible track record at identifying risk.

Until very recently, almost everyone at the Fed would have told you that the Fed cannot identify asset bubbles. This means that the Fed cannot tell when a firm has been buying assets at inflated prices. Without this ability, the Fed can only act in hindsight--once a risky investment has already blown up.

This is not just theory. The Federal Reserve was as sceptic of the idea of a housing bubble, it predicted the problems in the subprime mortgage market would be contained, and it failed to foresee that a financial crisis would unfold from the housing market decline.

In some sense, this is a problem of competence and diligence. The analysts at the Fed simply failed to see how the machinery of the mortgage market had taken over Wall Street and how the availability of easy credit had rotted away lending standards and driven up prices.

But the problem is actually much deeper.

The Future Is Dark

Fooling Around With Randomness

In any case, do we really want a managed market in which the Fed takes sides in this contest between capitalists? Perhaps it would be nice if we could know that the Fed would have sided with Dimon over Prince, making the right choice. But not only have reason to be confident the Fed would make the right choice, there's plenty of evidence that if it had this power in the past it would have made the wrong decisions.

At its heart, this proposal for hegemonic risk regulation by the Fed is a denial of what economist Friedrich Hayek identified as the knowledge problem. As economist Nassim Taleb would tell us, the future just isn't predictable enough for the Fed to be able to identify risk.

That's pretty bad. But there's an even worse problem: the regulators create systemic risk when they try to identify it.

Blowing Bubbles With Bernanke

The second problem with authorizing the Fed to directly impose its views of risk on the companies it supervises, is that this necessarily creates assets bubbles.

Here's how it works. If the Fed views an asset class as less risky, demand for that asset from financial firms will grow. Firms will want to hold more of the asset because they know the Fed will view this favourably.

This itself creates systemic risk. Instead of heterogeneous strategies employed by different financial firms, we wind up with a single, homogeneous strategy endorsed by the government. Regulation of risk in this way produces a herd behaviour.

This herd behaviour is made all the more harmful because it exacerbates the cost of error. When firms are free to choose diverse investment strategies, the systemic effects of being wrong are mitigated by the firms that got the market right. But when regulators have sapped diversity from the system, errors in judgment can put the entire financial system in crisis.

Note that herding--with its effect of asset bubbles and systemic risk--can occur even if the market only perceives the Fed favours certain assets. So even if the Fed doesn't actively use its authority, the market will anticipate future uses and investment homogeneity will occur. The very existence of the power creates a problem.

Politicized Banking

A third problem is that politics will inevitably intrude. The new bill gives the president more power over the Federal Reserve, including the power to appoint the head of the New York Fed. This will no doubt further politicize the Fed.

A more politicized Fed will be more likely to use its authority to regulate risk in ways only tangentially related to risk. It might encourage greater investment in politically favoured sectors--say, green technology or municipal securities. It could quite plausibly do this with economic rationales that will conceal the underlying political dynamic.

Of course, a financial system built around satisfying political demands instead of market demands is, in reality, far riskier. So we'll be setting ourselves up for another crisis when the costs of this distortion become apparent.

There's No Way This Can Work

In short, the desire for more regulation of risk is a well meaning mistake. Central bankers cannot identify what is risky or what the appropriate level of risk might be. Competitive theories about risk that are embodied in the divergent business strategies of rival financial firms cannot be resolved in advance and all attempt to do so will make the financial system less stable.

To make matters worse, we'll be destabilizing the system while creating an illusion of stability. If this thing passes, start your stop watches. Tick. Tick. Tick. Ka-boom.

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