Financial regulatory reform got a huge boost from the passage of health care reform.
This is a surprise. Only a few weeks ago, many political observers thought that the Obama administration had made a serious mistake by putting health care ahead of financial regulation on its legislative agenda. The idea was that the failure of health care reform would cripple the administration politically, taking down financial regulation as a collateral damage.
Now the opposite is happening, buoying the hopes of some who want a regulatory system that will make our financial system more stable, more honest, fairer, and less dependent on government backing.
Unfortunately, these hopes are misplaced. The problem is not just that the regulation coming out of the Senate finance committee is badly flawed—it is badly flawed—but that it’s not clear whether any regulations can fix our system.
The question is how much better of a financial system can regulations create beyond the system that arises from culturally conditioned behaviour. And the evidence is that regulatory supervision contributes almost nothing. Its effects are illusory.
What really matters is something that regulations cannot create or even ameliorate. The US financial system changed because the anthropology of Wall Street changed. Over the course of decades, the old conservatism of bankers who supported a hard and fast gold standard was replaced by over-confident, self-dealing risk takers arbitraging government actions—Fed interest rates, capital requirements, home ownership growth—in pursuit of profits.
The risk taking, the self-dealing, and the over-confidence all played a role in creating the conditions for our financial collapse. If bankers had been more humble about their ability to predict the future, they would have exercised more caution. If the rewards for risk-taking had been smaller and the rewards for humility greater, they might have been incentivized to study more carefully the potential risks.
Our regulatory system didn’t ameliorate the effects of this change in the culture of Wall Street. It exacerbated it. Capital requirements were skewed to encourage securitization and investment in securitized mortgages in particular. They also encouraged over-reliance on the ratings agencies rather than real investigation of risk. In fact, the rules punished those who took a different view of risk than the government.
The idea behind the current round of reform is that this time it will be different. This time we’ll get rules that really ameliorate the cultural shift. This time we’ll anticipate the perverse consequences in advance, we’ll keep the regulations tight enough that we’ll avoid loopholes for crafty traders to exploit, and we’ll make the finance sector behave more intelligently and more responsibly.
The confidence in the efficacy of the latest round of financial reform is completely unwanted. It appears to spring from a kind of wishful thinking. The culture of Wall Street has eroded to the point where it is heedlessly and recklessly taken on risk, so therefore we need regulation. But how do we know regulation can replace culture? What evidence is there that this works?
The fact is that there is none. We desire so badly that things run better that we are blind to the fact that a cultural and moral decline just cannot be ameliorated through regulation. There is no fix.
This is hardly a call to inaction. We should immediately attempt to lessen the effects of any regulations that tend to homogenize the markets, creating a rush into assets or strategies favoured by regulators. Getting rid of any role for ratings agencies in regulations would be a good start. Investors can protect themselves by investing only in firms in which they trust the ethical integrity of its leaders. Counter-parties should be wary of bankers with too much swagger and not enough humility. And, somehow, we need to insulate taxpayers from the losses by preventing future bailouts.
Nothing in the financial regulations making their way through Capitol Hill does anything to make this a reality. Instead, we’re just asked to trust that this time regulators won’t fail us.
Business Insider Emails & Alerts
Site highlights each day to your inbox.