Friday, October 24, 2008

Senior Regulators to Senate: Surprised at the failure of Voluntary Regulation. Where They Really That Naïve?

".. for the imagination of man's heart is evil from his youth" (genesis 8:21)

Three senior regulators were apparently very surprised by the behavior of financial institutions and especially investment banks and the part they played in the current crisis. Where they really that naïve? I find it a bit hard to believe.

What the regulators had to say

Chris Cox, chairman of the Securities and Exchange Commission, said in congressional testimony Thursday that he and other regulators have learned many lessons, chiefly that "voluntary regulation does not work." Apparently Cox urged Congress to fill "regulatory gaps" that are still putting the economy at risk. "The lessons of the credit crisis all point to the need for strong and effective regulation, but without major holes or gaps." Cox said Congress should appoint a select committee to address the challenges of regulation on a comprehensive basis.

Alan Greenspan, former Fed chief, admitted he made a mistake in trusting the free markets to regulate themselves. Alan Greenspan said: 'I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well.'

Where they really that naïve?

Apparently voluntary regulation does not work. That's a big surprise there, isn't it? Voluntary regulation is very much like asking a tiger to consider the implications of his hunting habits on the deer population. It's simply against his nature. Without proper enforcement will never work. They might as well have sent an email to financial institutions reading: we know you can make a lot of money but please take the time to stop and consider the possible unpleasant implications you making money might have. Oh and by the way invest millions of dollars in risk management sophisticated enough to actually manage the risks you're taking.

It's never that simple though. Regulators basically expected financial institutions to be professional enough to care about their own survival and to invest proper capital and effort into adequate risk management which should ultimately lead to a better competitive position in the market.

A financial institution which has the ability to manage its risks better can also properly price credit given thus asking for a higher risk premium from more risky clients. These clients, in turn, will obviously shop around for cheaper rates naturally offered by banks that lack the ability to properly price risks. The latter banks, in theory, should be the first to crumble under crisis.
The problem is that no CEO of a financial institution can afford to get left behind while other are cleaning up on the securitization of subprime mortgages and other exotic derivatives which apparently no one really understood.

Surely senior regulators understand how things work

In short, they do. We can't and mustn't trifle with these outstanding individuals who have obviously shown considerable talent and ability to get to where they are. What happened then?
I believe that much like other painful surprises the current crisis is a result of a certain conception of reality proven wrong. I believe the reasons behind the failure of intelligence and law enforcement agencies at 9/11 are similar in many ways to the reasons behind this crisis. When a certain concept or conception have taken place and hold over a group of people, from a couple to a country and the world, it is very difficult to break away from it.

Voluntary regulation, as a concept, has a lot of reason behind it as I explained earlier. The human mind has a tendency to let sleeping dogs lie and mark a big v sign on things that don't really need to be discussed again.

This sort of groupthink is common to many aspects of human lives. That is also why I hailed the Socratic Method in my previous post on the Gone Fishin' Portfolio.

I hold a deterministic point of view on life. I don't really believe this crisis could have been avoided as many many different streams converged into the river that is the credit crunch. Many smaller and bigger failures has to happen for a massive boom like this to happen.
Now that it has happen we are all experts in what should have been done and what needs to be done but all we are doing is preparing for the previous war when the next one will surely surprise us as well.

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Image by: Queen roly

1 comment:

Praveen Puri said...

Greenspan, especially, was a follower of Ayn Rand and believed in libertarianism and free markets.

So he was naive in the sense that he stuck to his philosophy - even when he should have watched what was happening.

When reality and your model of reality disagree, then reality wins.

But, the irony is that this wasn't all a free market failure. A lot of this trouble is because Greenspan himself lowered interest rates to "protect" the economy after the dot com crash and held them lower for too long.

In a true free market, a central banker would not have so much influence.

Personally, I think the ideal solution is to have a few, well-thought rules that allow free markets when only the individual companies could get hurt, and concentrate on preventing situations to snowball out of control where there is the potential for systematic collapse.