Tightening the Regulatory Net

There’s good news and bad news in Paul Krugman’s NYT op-ed this morning. On the good news side of the ledger Dr. Krugman explains pretty clearly what I’ve thought has been the dirty little secret in the current credit crisis:

That, in brief, is what happened in 1930-1931, making the Great Depression the disaster it was. So Congress tried to make sure it would never happen again by creating a system of regulations and guarantees that provided a safety net for the financial system.

And we all lived happily for a while — but not for ever after.

Wall Street chafed at regulations that limited risk, but also limited potential profits. And little by little it wriggled free — partly by persuading politicians to relax the rules, but mainly by creating a “shadow banking system” that relied on complex financial arrangements to bypass regulations designed to ensure that banking was safe.

For example, in the old system, savers had federally insured deposits in tightly regulated savings banks, and banks used that money to make home loans. Over time, however, this was partly replaced by a system in which savers put their money in funds that bought asset-backed commercial paper from special investment vehicles that bought collateralized debt obligations created from securitized mortgages — with nary a regulator in sight.

As the years went by, the shadow banking system took over more and more of the banking business, because the unregulated players in this system seemed to offer better deals than conventional banks. Meanwhile, those who worried about the fact that this brave new world of finance lacked a safety net were dismissed as hopelessly old-fashioned.

But that brings us to what I think is the bad news side of the ledger. The business, academic, and civic environments in the country are very different today than the ones that were in place 70 years ago. The academy was extremely conservative. Right wing, even. And the government was not nearly so dominated by career bureaucrats and politicians as it is now. We didn’t have the continent-spanning financial giants then that we do now. Banks were local, not the size of medium-sized countries.

Do the leaders of today have the wisdom, experience, and clear-sightedness now to put a regulatory framework into place which will put the obviously necessary controls into place without hobbling our economy into permanent stagnation? Frankly, I doubt it.

2 comments… add one
  • Dave,

    The big issue, for instance with Bear Stearns this week, is that when Glass Steagall was repealed, the government neglected to formulate a discount policy vis-a-vis brokers. The banks continued to hoard capital and the Fed ignored the credit needs of brokers. Now, they have seen the light, but only to late for a venerable i-bank that has generally been the class of Wall Street.

    The financial services industry is already the most regulated industry on the planet. In my opinion, this isn’t a question of “what more laws should we have?” but “how can we get government to institute policies that reflect modern realities?”

    Krugman also has ignored the policies that led to CDOs becoming so ubiquitous. The current crisis goes back to the 70s when banks were being pressured into making questionable loans by regulators who were more concerned with politics than sound monetary policy. The banks had to find a way to mitigate the added risk they were being compelled to take on, so they packaged and sold off the risk.

    I’m not saying that the banks and brokers are innocent. CDOs by themselves aren’t the problem, but the amount of leverage used in the transactions. Basically, the Fed engineered an arbitrage with CDOs and Treasuries, something they can’t do too often, but a risk that seems to have the best chance of working. Krugman doesn’t like this arbitrage, and I understand his misgivings, but I think that in this case he’ll end up being wrong.

    Again, this is only my opinion, but: when the Bush Administration and Congress served their buddies in the credit cartel by tightening bankruptcy laws, they took out the very brake that had kept that market in check. Making bad loans was no longer a cost of doing business. Bad loans are more easily made than high-quality loans, but without the possibility that these loans might cost the banks, an atmosphere of singing while the ship sank just went on and on.

    Both government and industry deserve the blame. But instead of a cold assessment of the mistakes that were made, we get calls for yet more incompetent regulation and more drastic bail-outs.

  • That’s an interesting observation, Dan. Lowering the cost of overextending credit (which the bankruptcy reforms did) could certainly have helped spark off the current problems.

Leave a Comment