Regulators Cannot Avert Next Crisis

Made mistakes. American politicians, central banks and regulators were just as eager as speculators to expand the housing bubble. They just had a bigger pump.

The US Federal Reserve lowered interest rates from 6.5 percent to 1 percent between 2001 and 2003, and housing prices soared. Starting in 1995, the government threatened banks and thrifts with regulations and legal challenges if they did not extend more loans to poor neighbourhoods and a government-sponsored company such as Fannie Mae used its state guarantees to purchase more risky loans and expand the sub-prime market.

Is the solution to the crisis really to give more power to people and institutions that contributed to bringing it about?

The problem with regulation is that it is always a response to the last crisis. Generals fight the last war and always try to avoid the mistakes made then. So we get new rules that target the mistakes that everybody already knows they must avoid. The next possible crisis and its causes are so far unknown, and our regulations may have no effect or even make them worse.

After the exposure of accounting scandals in companies such as Enron, we have seen more drastic accounting regulations. We all wanted to avoid another Enron. “Fair value accounting” was one of the results, which means that financial institutions had to mark their assets to market. If a bank has mortgage-backed securities for sale, their value is registered as the price it could get if it sold them on the market today, rather than taking historic prices into account.

It sounds reasonable, but the problem is that when there is panic in the market, no liquidity and no buyers, that price is very low. So suddenly all institutions see the value of their assets drop at the same time. If they sell to make up for the loss, the prices fall even more, and accountants keep marking down assets. The result is that a bank or thrift that looked very stable a few days ago can suddenly turn out to be insolvent, at least on paper.

William Isaac, who used to be chairman of the Federal Deposit Insurance Corporation, has said that if fair value accounting was in place in the 1980s, all the big banks in the US would have collapsed and the recession might have become a depression.

These accounting rules are “like fighting a fire with gasoline”, as Steve Forbes has pointed out.

In other words, regulation that was introduced to solve yesterday’s problems can easily become a big problem around the corner.

The only thing we know for sure is that we don’t know where the next problem is going to come from. Our best way of preparing is to be flexible and to make sure that individuals and institutions are ready to learn and adapt as soon as new information is available. Regulation that locks in particular solutions or blocks others could stand in the way of that flexibility.

Another result of the accounting scandals was the Sarbanes-Oxley Act of 2002, which required US companies to introduce rigorous internal controls and to send regular, detailed financial reports to the federal authorities. The result has been new costs for American companies, fewer public offerings and a flight of talented directors.

The present financial crisis has swept away the independent investment banks on Wall Street. It is now obvious that they couldn’t afford the risks they took without having bank deposits that have made life easier for big commercial banks. But why did independent investment banks evolve in the first place? Because American politicians outlawed universal banks as part of the New Deal, a ban that was in place for 66 years.

The Glass-Steagall Act, which enforced that ban, was repealed in 1999: one piece of deregulation on which some people now blame the crisis. On the contrary, it was important and it was done in the nick of time.

If it hadn’t been repealed, J.P. Morgan would not have been able to buy Bear Stearns, Bank of America could not have bought Merrill Lynch and Morgan Stanley and Goldman Sachs would not have been able to save themselves by becoming bank holding companies.

Regulations and controls often result in new difficulties even when the intentions of policymakers are good and the hopes are real. That does not even begin to address the problem that a lot of new regulations are just symbols, enacted to show people that politicians have done something, even if they know that it does not really address the problem. It follows the politicians’ logic from the British television series Yes, Prime Minister: “Something must be done. This is something. Therefore we must do it.”

This logic is as old as the crises. After the collapse of the South Sea Bubble in 1720, the British parliament delayed the Industrial Revolution by impeding the free formation of joint stock companies for more than 100 years.

And after the Depression, American politicians made risk-handling more difficult for two generations by banning stock options.

Regulators and politicians always fight the last crisis, and when they do they run the risk of making the next crisis more severe.

As we don’t know what the next trigger will be, we can’t regulate against it without introducing such drastic measures that financial markets cease to function effectively.

And that would be a terrible loss, much, much worse than any financial crisis we could imagine. Buying bad assets from financial institutions may be a bad idea and may cost the US treasury $US700 billion, but financial markets help the world economy to create that amount twice a week.

Speculators and investment banks have shown that it is difficult to keep a cool head when there are large sums of money at stake. But the same goes for politicians and regulators. And the only thing more dangerous than financial crises may be our way of responding to them.