Here's Why The Idea Of A Systemic Risk Regulator Is A Truly Terrible Idea

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(This guest post originally appeared at the author’s blog)

Inadvertently, the New York Times gets at the dilemma the government faces as it tries to set up a systemic regulator: 

The issue is one of the most fundamental in the contentious effort to overhaul regulation after the financial crisis, and addresses one of the primary lessons of the near debacle: that no one had been assigned to ensure the stability of the system as a whole and detect the kinds of excessive risk-taking and imbalances that could rock an entire economy.

Assigning the Treasury Department the job of spotting incipient trouble and addressing it quickly has support among senators from both parties, though several important provisions, including whether the council would have the ability to bypass existing banking regulators and impose its own rules on huge financial firms, remain to be worked out.

Sounds easy, doesn’t it? Just “spot incipient trouble and address it quickly.” How come no one thought of that before? The problem, of course, is that it’s impossible for any regulator—for any human—to reliably tell, ahead of time, the difference between a financial practice that constitutes a budding threat to the system and the typical, harmless follies that are hatched in the financial markets every day.

 Want evidence? Let’s play what-if. What if the administration’s planned super-systemic regulator had been in place as the housing bubble inflated? What would the agency have done to forestall disaster? Easy. It would have told lenders to stop writing subprime ninja loans, 90-10-10 piggybacks, and the other dodgy products that ended up going boom. And it might have told Wall Street to stop securitizing subprime paper and selling it as if it were investment grade. It might have had a little chat with the ratings agencies, as well. If it had done all that, yes, the calamity would have likely been averted. 

But wait–regulators are already in place who might have taken those very measures. The OCC exists to ensure the safety and soundness of the banking system; one of the ways it does that is by getting in bankers’ grills and telling them to cut out the iffy practices. That’s why God gave us MOUs and cease-and-desist orders. The S.E.C. could have told Lehman and the rest that it really, really didn’t like the idea of turning so much subprime paper into AAA-rated securities, so why not leave subprime alone and move on to the next big innovation.

 But the regulators didn’t do that. That’s not because they’re lazy or incompetent. It’s because they’re people, and people can’t predict the future. The regulators, along with just about everybody else, had no clue how badly the housing bubble would end.  

I am assuming this new super-systemic regulator will be staffed with mere mortals, just like the existing ones are. If that’s the case, I don’t see how it will be any more effective than the old ones.

 But the “systemic regulator” won’t just be ineffective. It will almost certainly be positively harmful to the system, too.  

Let’s play another what-if. What if the systemic regulator had been in place in the 1990s, during the rise of the monoline credit card lenders? The agency might have argued it saw a budding systemic risk: here were companies engaged in unsecured lending on a massive scale, often to consumers of doubtful credit quality. It was the consumer, not the lender, who set the size of the loan and the rate of repayment. As the companies pushed growth, they were force-feeding consumers with new, unsustainable debt. The companies themselves were dangerously non-diversified. And the funding of it all. . . .

 In the fullness of time, we now know that our hypothetical regulator would have had a point. The monolines mostly collapsed, usually because they overreached on growth and ran into credit problems. The few that didn’t either bought themselves deposit bases or sold out to banks. The regulator was right; the monoline card lenders were mostly accidents waiting to happen.  

And yet . . . The brief heyday of the monoline brought about enormous innovations in card lending that made credit cheaper and more widely available to consumers. If the companies had simply been, say,  shuffled into the arms of the big banks by regulatory fiat, those innovations never would have happened. So even though the business model didn’t last, the consumer benefited anyway. What good would a systemic regulator have done the economy or the financial system if, in the name of “spotting incipient trouble,” it had strangled the business in its crib?  

So let’s see. The new super-regulator won’t likely be able to head off the next crisis, but will be in a position to stifle worthwhile financial innovation. I fail to see the upside.  

Look, I wish there some magic wand the government could wave that could reliably prevent the next financial crisis. Maybe there is a wand, but nobody’s thought of it yet. But the planned super-duper systemic regulator won’t do the trick. It will do more harm than good. 

What do you think? Let me know!

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