Thursday, June 12, 2008

More on Regulation

Megan McArdle has a followup post on financial regulation (here's the original post). As usual she makes some good points:

But assuming arguendo that the regulators are every bit as smart and well-trained as the analysts they regulate. This is adequate only for certain kinds of regulation: the kind where the goals of the regulators are fundamentally different from those of the regulated.

If they could get away with it, some companies would lie in their advertising or sell adulterated goods; we want regulators to catch them at it. Companies have an incentive to present an inaccurate picture of their financial well being to investors; that's what auditors are for. Depositors in an FDIC-insured bank have no incentive to check on whether the bank is sound, so we put regulators in charge of doing it for us.

But what happened in the markets was not a case of fraud. It was a case of the systemic mispricing of credit risk. More importantly, it was a case of the systemic mispricing of credit risk on the buy side: Bear Stearns didn't fail because it had originated too many dodgy securities, but because it had bought too many. The banks have just as much incentive to price risk correctly as the regulators do--probably more, actually, because the regulators are unlikely to get fired if they miss one. It's hard to make a clear case for managerial moral hazard as a result of the Bear Stearns bailout--they all lost their jobs.

I'm coming to the conclusion that the only additional regulation that makes sense is an enhanced capital requirement for these investment banks. Anything else would seem to be too heavy handed and would likely have unintended consequences.

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