Great Moments in Financial Regulation

Congress is moving towards bipartisan agreement on changes to financial regulation, claiming to address the root causes of the market crash of 2008. The centerpiece of this legislation includes creating a group of officials to regulate "systemic risk." Unfortunately, instead of advancing transparency and empowering investors, it will do very little to address systemic risk, while adversely affecting many of America's most successful non-financial businesses. In fact, combined with other provisions of the bill, government officials will be in a position to substitute their judgment for that of investors.

Almost everyone can agree that the causes of the recent financial crisis included mistakes on all sides. Financial institutions offered loans to borrowers who could not repay them. Government-sponsored enterprises and government policy encouraged these sub-prime loans, which were then repackaged as securities and sold with high investment ratings (thanks to government backing) to buyers who did not fully assess the risks. All proceeded on the theory that asset prices would keep rising. Buyers, sellers, and government agencies mistakenly placed too much reliance on the supposed insight and expertise of credit rating agencies. When the music stopped, it became clear that nobody knew what the instruments, including their underlying assets, were worth. Tumbling investor confidence wreaked its special brand of havoc as liquidity evaporated and investors fled for the hills. In the case of the largest banks, the end result was hundreds of billions of dollars of U.S. taxpayer assistance.

The fundamentally wrong conclusion from these facts, now seized upon by the Administration and politicians on both sides of the aisle, is that another, cleverly designed government institution is the prescription for our present ills. Given that most of the "bailed out" institutions were the most tightly regulated, even in terms of capital standards specifically designed to prevent the kind of bank run we witnessed, the "safety and soundness" approach to bank regulation itself needs to be reexamined. The end result of this traditional regulatory approach is that government bureaucrats tightly control the information that investors can learn about a financial institution, limiting proper analysis. Even underwriters of a bank's securities offering have to do their due diligence inquiry without access to the candid assessments by bank examiners of the bank's condition. How can "systemically significant" financial institutions in the information age not be fully transparent?

The bill proposed by Senator Christopher Dodd, along with the Treasury and House versions, simply doubles down on this same approach. The proposals seek to extend bank-style regulation to any American company that is deemed to be systemically significant--a "threat" to the financial system. The powers extend to companies and, ultimately, financial products. The new regulatory body is to be both omniscient and omnipotent--supposedly able to predict future market excesses and use sweeping powers to stop them. If the bill becomes law, two outcomes are likely: the systemic risk regulator will prove as incapable of predicting the future as everyone else in history, and the regulator will prove so overly cautious that it prevents financial market innovation and stifles economic growth. Even if the regulator could accurately predict a problem, overwhelming political pressures prevent mere mortals from taking effective action, precisely because one person's asset bubble is another person's livelihood. Thus, the effect of the systemic regulator will be to substitute government judgments for investor judgments, deciding for investors whether a product merits investment. The effect will be compounded with the addition of the new consumer financial products bureau in the Dodd bill.

We should be skeptical about expecting a regulator to make accurate, one-size-fits-all judgments about the merit of specific financial products. For example, before 1996, certain initial public offerings of stocks were subject to merit review in certain states, where the state decided if a security is a "bad" investment and thus not appropriate to be offered to its citizens. In fact, this is exactly what happened to Apple Computer when it first went public in 1980. Massachusetts prohibited the offering of Apple shares because they were "too risky," and Apple did not even bother to offer its shares in Illinois due to strict state laws on new issues. What if federal bureaucrats had had the power to impose their judgment on a "risky" financial product (such as an IPO) on a nationwide scale, or every state followed Massachusetts' lead? Would Apple have become the successful company that it is today? While the Dodd bill probably will not affect IPOs, merit regulation (despite regulators' best intentions) can harm investors and other market participants.

Instead of creating a new super regulator incapable of meeting superhuman expectations, Congress should focus on increasing transparency and giving regulators, creditors, and investors better and more timely information to perceive risks and make better informed investment decisions. Markets froze in the fall of 2008 because no one could be sure of the financial condition of financial institutions and their counterparties. For all the government's extraordinary intervention, the markets showed their greatest improvement after the Fed's imperfect stress tests were made public in early 2009. This level of transparency did not exist during the market crisis and most likely would have seriously limited its impact. By empowering investors and market participants with full and open information, we limit systemic risk while also encouraging growth--and save billions of dollars in avoiding new government bureaucracies and the costs they impose.

Paul S. Atkins is a visiting scholar at AEI.

Photo Credit: iStockphoto/mddphoto

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