Most Popular
1. Banking Crisis is Stocks Bull Market Buying Opportunity - Nadeem_Walayat
2.The Crypto Signal for the Precious Metals Market - P_Radomski_CFA
3. One Possible Outcome to a New World Order - Raymond_Matison
4.Nvidia Blow Off Top - Flying High like the Phoenix too Close to the Sun - Nadeem_Walayat
5. Apple AAPL Stock Trend and Earnings Analysis - Nadeem_Walayat
6.AI, Stocks, and Gold Stocks – Connected After All - P_Radomski_CFA
7.Stock Market CHEAT SHEET - - Nadeem_Walayat
8.US Debt Ceiling Crisis Smoke and Mirrors Circus - Nadeem_Walayat
9.Silver Price May Explode - Avi_Gilburt
10.More US Banks Could Collapse -- A Lot More- EWI
Last 7 days
Stock Market Volatility (VIX) - 25th Mar 24
Stock Market Investor Sentiment - 25th Mar 24
The Federal Reserve Didn't Do Anything But It Had Plenty to Say - 25th Mar 24
Stock Market Breadth - 24th Mar 24
Stock Market Margin Debt Indicator - 24th Mar 24
It’s Easy to Scream Stocks Bubble! - 24th Mar 24
Stocks: What to Make of All This Insider Selling- 24th Mar 24
Money Supply Continues To Fall, Economy Worsens – Investors Don’t Care - 24th Mar 24
Get an Edge in the Crypto Market with Order Flow - 24th Mar 24
US Presidential Election Cycle and Recessions - 18th Mar 24
US Recession Already Happened in 2022! - 18th Mar 24
AI can now remember everything you say - 18th Mar 24
Bitcoin Crypto Mania 2024 - MicroStrategy MSTR Blow off Top! - 14th Mar 24
Bitcoin Gravy Train Trend Forecast 2024 - 11th Mar 24
Gold and the Long-Term Inflation Cycle - 11th Mar 24
Fed’s Next Intertest Rate Move might not align with popular consensus - 11th Mar 24
Two Reasons The Fed Manipulates Interest Rates - 11th Mar 24
US Dollar Trend 2024 - 9th Mar 2024
The Bond Trade and Interest Rates - 9th Mar 2024
Investors Don’t Believe the Gold Rally, Still Prefer General Stocks - 9th Mar 2024
Paper Gold Vs. Real Gold: It's Important to Know the Difference - 9th Mar 2024
Stocks: What This "Record Extreme" Indicator May Be Signaling - 9th Mar 2024
My 3 Favorite Trade Setups - Elliott Wave Course - 9th Mar 2024
Bitcoin Crypto Bubble Mania! - 4th Mar 2024
US Interest Rates - When WIll the Fed Pivot - 1st Mar 2024
S&P Stock Market Real Earnings Yield - 29th Feb 2024
US Unemployment is a Fake Statistic - 29th Feb 2024
U.S. financial market’s “Weimar phase” impact to your fiat and digital assets - 29th Feb 2024
What a Breakdown in Silver Mining Stocks! What an Opportunity! - 29th Feb 2024
Why AI will Soon become SA - Synthetic Intelligence - The Machine Learning Megatrend - 29th Feb 2024
Keep Calm and Carry on Buying Quantum AI Tech Stocks - 19th Feb 24

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

Systemic Risk of Financial Collapse Resulting in Fuzzy Regulatory Oversight

Politics / Market Regulation Oct 15, 2009 - 02:49 PM GMT

By: Stephen_Mauzy

Politics

Best Financial Markets Analysis Article"Systemic risk" is the new financial term du jour. I suppose that's good news for all of us in the finance biz. The previous term du jour, "moral hazard," had months ago been talked, debated, lectured, explained, and milked to death. I suspect that a few months hence, systemic risk — the risk of total financial system or market collapse — will have suffered a similar fate.


In the meantime, the current obsession with systemic risk is understandable. After all, we came darn close to experiencing it, with every money-center bank, most secondary banks, and many tertiary banks verging on collapse only a few months ago. That close call handed politicians a gold-plated "opportunity to do things you couldn't do before."

One of those things is increasing regulatory oversight of the financial sector. In particular, the Obama Administration would like to give the Federal Reserve the authority to regulate any Tier 1 financial-holding company — a fuzzy category expected to include all commercial and investment banks, though likely to exclude private equity and hedge funds. The president's proposal includes an oversight council, to be chaired by the treasury secretary. This council would give a key role to the Federal Reserve chairman while marshalling the forces of six other discrete agencies, including the SEC, FDIC, CFTC, and Federal Housing Finance Agency.

But does it really matter? If history is any guide, and it should be, the new regulatory regime will likely suffer the same fecklessness as previous regimes, because of at least two intractable shortcomings: First, the President's proposed oversight council, despite being pitched as a cohesive unit, is composed of entities representing different constituencies. Therefore, it's automatically larded with representatives of different agendas, each of which will instinctively work against each other to protect his own turf when cooperation is needed most.

Second, government regulation simply doesn't work. Nobel Prize winning economist George Stigler, who garnered fame for developing the "Economic Theory of Regulation," better known as the "Theory of Regulatory Capture," postulated 50 years ago that interest groups and political representatives will use the regulatory powers of government to shape laws and regulations to their advantage. It's no coincidence that Treasury Department heads originate from Wall Street.

Historian and ardent anticapitalist Gabriel Kolko explicated the phenomenon of capture in his book the Triumph of Conservatism. Kolko was one of the first academics to criticize the Progressive Era — the period of reform that lasted from the 1890s to the 1920s. Kolko's research discovered that free enterprise and competition were vibrant and expanding during the first two decades of the 20th century, until businesses began petitioning government for regulation in order to stem competition. Indeed, the 1913 Federal Reserve Act was the product of a banking reform movement initiated by big banks seeking to insulate themselves from small-bank competition.

An unintended consequence of capture — one on par with stifling competition — is that regulators, by guaranteeing market integrity, dilute incentives for firms and investors to exercise diligence. Investors grow lax, believing someone has their back when no one does.

It's a recipe for disaster when you consider that the regulators are always outmaneuvered. Economist Hyman Minsky, in his "Financial Instability Hypothesis," noted that banks seek profits by financing activity and bankers. Like all entrepreneurs in a capitalist economy, bankers are aware that innovation enables profits; thus, bankers (Minsky uses the word generically for all financial intermediaries) strive to innovate in the assets they acquire and the liabilities they market.

It's a mismatch: an entrepreneurial mentality permeates private banking, and a stasis mentality permeates governments. Government employees lack incentives to go above and beyond their job descriptions, because government lacks the carrot of profit and the stick of bankruptcy. The only incentive government responds to is the opportunity to expand its presence into that which is already known; hence, $50 billion is forked over to a shopworn, dilapidated General Motors.

The Obama Administration's proposal is already as yesterday as General Motors. Yes, it strengthens firewalls between banks and their affiliates to prevent conflicts of interest; it imposes new risk-retention minimum standards — 5 percent — in the securitization market, and requires institutions to issue standardized contracts; and it strengthens the oversight of clearing and payment-settlement organizations. It also mandates a rapid resolution plan (whatever that means) in case these Tier 1 firms threaten the nation's economic health (but who determines that?).

Unfortunately, the next systemic risk will not emerge from Tier 1 financial firms any more than it will emerge from reckless savings and loan lending or overinvestment in dotcom businesses. But that fact fails to temper dreams that it will be otherwise.

In a July 26 New York Times op-ed, a popular Princeton economist (hint: not Paul Krugman) closed his eyes real tight and imagined what the world would have been like had the President's systemic-risk regulator existed in 2005. This economist imagined the regulator maintaining a vigilant eye on the growing mound of residential-backed collateralized debt securities.

He then imagined this same regulator questioning the legitimacy of all those easily parsed out triple-A bond ratings. This regulator even possessed sufficient wisdom to questioned American International Group's addiction to writing credit default swaps on all those collateralized debt obligations the banks were issuing.

Of course, this Princeton economist's omniscient regulator is the antithesis of the real-world heads of the SEC, who also ignored Boston investor Harry Makropoulos — the guy who mailed SEC investigators a 29-page tip sheet, explicating Bernie Madoff's secretive business practices, lack of oversight, and suspiciously high profits.

The year 2005 was unremarkable, but steady: in other words, a perfect year for writing as many credit default swaps as the computer could generate. It was also an interregnum from the Dow Jones Industrial Average's 3,000-point upswing over 2003 and 2004 and the additional 3,000-point upswing that occurred over 2006 and 2007. In short, the stock market of 2003 through 2007 was very good to many equity investors, and when times are very good, markets grow very risky (another salient point noted in Minsky's "Financial Instability Hypothesis").

But good markets are exactly when regulators become most complacent — vigilance being the greatest risk to one's bureaucratic career. Imagine the vigilant regulator confronted with this comment from Rep. Barney Frank (D-MA) at the House Financial Services Committee hearing on September 10, 2003:

I worry, frankly, that there's a tension here. The more people, in my judgment, exaggerate a threat of safety and soundness, the more people conjure up the possibility of serious financial losses to the Treasury, which I do not see. I think we see entities that are fundamentally sound financially and withstand some of the disaster scenarios.

What's a self-interested regulator to do?

The answer is easy to fathom, which is why we should jettison our fiat money system in favor of a gold or multicommodity-metal system (such as gold, platinum, silver, and copper). While we're at it, we should jettison fractional-reserve banking in favor of full-reserve banking. A full-reserve banking system would prevent both overextension of credit and loss of confidence in the financial system. Both actions would remove the financial system from the aegis of a constantly wrong regulatory hegemony and place it under the aegis of a mostly right free market.

But if you prefer the status quo and believe President Obama's latest proposal is the preferred option, because it puts all our regulators on the same page, I suggest glancing across the Atlantic to our close kin the British, and their putatively cohesive Financial Services Authority. Then ask yourself this: Did the FSA shield the United Kingdom from systemic risk any better than our current hodgepodge of regulatory agencies shielded us?

Stephen Mauzy is a CFA Charterholder, a financial writer, principal of S.P. Mauzy & Associates, and author of the forthcoming Prentice-Hall book The Wealth Portfolio. Send him mail. See Stephen Mauzy's article archives. Comment on the blog.


© 2005-2022 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in