Regulating Risk

I think the key factor in a bubble is that most people develop irrational expectations and that there is no way government regulators will be able to, or even try to, stop it.

Last year the CEOs of Lehman and Bear each lost something like a billion dollars.

If people like that were willing to put so much (almost all) of their own money on the line how will a regulator stop the firms they run?

I do not think bubbles can be stopped but their cost can be minimized by adopting regulations that will help even if regulators get swept up in the bubble.

The best idea I have heard on this is that any firm that is systematically important has to have its debt be convertible to equity in the event of a regulatory event.

This way the government would be able to force debt holders to absorb their share of the losses without the government needing to force an actual bankruptcy.

During a bubble firms would feel no need to escape this requirement because they would not believe that there will be any regulatory events.

The goal should be to implement this and find other similar requirements that will mitigate the crashing of future bubbles.

Beyond that increasing leverage is the most important thing. However in the last bubble there were leverage requirements that firms got around by doing off balance sheet transactions.

The government should do what it can to stop this but there are many ways to hide an increase in leverage. In a bubble firms will do their best to increase leverage.

Both Krugman and Joe Nocera see serious, serious issues with Plan Obama. No new regulation of ratings agencies like Moody’s; no regulation of designer derivatives; banks “too big too fail” still allowed.

So, other than not tightening regulations on the three main causes of the financial sector meltdown, it’s a great plan.

"The Fed" is the wrong place, because of course, "The Fed" is independent entity from the US Government. It's called the Fed, but that's a misnomer.

The Fed works for the bankers and the bankers work for the guys with the money who are too big to fail.

So the Fed is the wrong place to look for regulation that's opposed to their interests.

Kevin Drum >"...could we create an agency like the CBO, but charged with monitoring systemic risk in the financial system?..."

Yes, of course "we" could but "we" are not likely to because of the current power of "big money".

What we NEED is a real monetary system & not one based on fantasy delusions fostered by scribblings of long dead elites. A monetary system based on the laws of biology, chemistry & physics, the real world. No externalities period.

Start with the work of the Odum brothers and build from there.

Oh and ignore Looneybury who is babbling from the 19th Century mind set (the delusion of the elite) & has zero clue about 21 Century reality.

Of course it won't happen because "we" don't have the balls to tell "big money" & their mouthpieces/shills (Looneybury for instance) to go screw themselves.

"If you don't deal with reality, reality will deal with you" - C.J. Campbell

So you want a Systemic Risk Facility whose job it is to anticipate problems, but will basically sit on its hands until an emergency occurs. Ok, maybe they will issue a boring report now and then.

You need an institution with the capability of ramping up and ramping down as the situation demands. That would be the Fed. You need an institution with solid ties to academia, both social and via small grants or salaries. That would be the Fed. You want an institution with a deep institutional knowledge of financial markets. That would be... the Fed.

Any system will steer off track sometimes if it has a certain amount of energy and is some allowed random movement, even one with mechanisms to prevent this. As an analogy, this can be seen in biological systems as cancer or simply allergies.

Now, better mechanisms mean better containment and fewer misdirections toward undesirable outcomes in a system. But as Krugman has noted, financial crises seem to be becoming more common. So make no mistake, we need to find better mechanisms for keeping our financial systems harnessed toward productive ends (as opposed to utter disaster), with appropriate feedback and boundary systems.

Now, the problem with the concept of "too big to fail" is that nothing is too big to fail. And we did have some failures (Lehman). If we wait long enough, one of these banks will indeed fail (hopefully not in my lifetime) and bring about a catastrophic crisis (not just a 10 year stagnation, or nasty recession). So the stakes are high. On the whole, as bad as it is, I think we got away lucky this time.

We probably need every mechanism at our disposal. So an ubber regulator is probably needed, but the only problem is that it only deals with large fluctuations within the financial system, and not the incremental steps that led to them. Such fluctuations unfortunately, probably carry a lot of momentum, so really are hard to regulate, no matter what the agency. This sort of like when your doctor steps in, either to prescribe an antihistamine, or perhaps chemotherapy.

So the additional, more immediate and incremental feedback systems and boundaries really should be thought through. (Sort of like your body having a properly functioning immune system). What about independent rating agencies for systemic risk? Banks are rated, and they pay insurance premiums to the government for their systemic risk. What about the old fashion boundary of segregating risk by defining what types of risk certain types of banks take on, and setting up separate rules for each type of bank?

So my point here is not really to define the best policy (there are surely better people), but just point out that the smaller everyday feedback and boundaries for the financial system are probably a lot more important than the ultimate ubber regulator.

Good bloody lord, what half-learned populist tripe. Member banks have to buy non-voting stock in the regional reserves, which effectiely acts like a base reserve deposit. A strange system to say the least, but not ownership in any real sense.

A perfect illustration of the dangers of populism, fundamental ignorance combined with passion leads to idiocy.

If one had bothered to read in detail the description of the Systematic Risk Regulator, either in the 2008 US Treasury paper (quite good actually, I learnt items about regulatory history in the US of A) or that formal paper from the present US administration (rather than 2nd hand accounts), one should have taken away that the Sysematic Risk Regulator aims to have a multi sector (or sub-sector, relative to the financial sector in all its components, banking, the significant non-bank sector, etc) to better apprehend what has become significant cross-bank to non-bank risk via counterparty and cross credit exposure. It also recognised that in a rather more tightly intertwined world - the 21st century monetary system if you will, single bank prudential focus misses a serious risk of multi-institutional risk - that is it may seem reasonable to let a Bear Sterns take a certain level of risk on its own, when the regulator is effectively just looking at that risk, but it may become collectively dangerous, in particular in areas where one might expect "contamination" or panic.

There is a natural tension between individual financial institution oversight and a systematic view - on an individual level, an institution may be perfectly fine and well-placed; a collective view might say there is a real problem with overall system exposure to untested exotic mortgage based securities, and that while at a 15% of assets exposre (total system) that looks like acceptable experimentation, at 30% of assets exposure, that looks like a time bomb. The sort of view that does not presently exist in a formalised way in most financial regulatory systems, and is not codified as an objective point of action (making taking that action difficult pre-crisis; post crisis of course it is "obvious" to everyone and was clearly everyone else's fault - pre crisis the Left would have wailed on about the overweening reach of the Bankers of the Fed... and the American Right would have come up with even queerer anti-Central Banking as a concept conspiracy theory).

Once one understands this is not simply bank financial regulation, but financial system supra-oversight, then one should understand (if one understands the role of the institutions) that there are really only two institutional choices. Treasury / Ministry of Finance or Central Bank for these roles.

What Drum describes is merely a research and commentary office. That is absurd, and merely highlights that he is simply reacting, rather than bothering to do some deeper reading. In any event, to be an effective Regulator (rather than mere commentary office), such an entity needs liquidity tools (ahem, the Cen Bank), needs experience and staffing for national level on-site supervision for institutional verifications (ahem, the Cen Bank), needs macro-level financial and wider economic analytical staffing (ahe, the Cen Bank), needs a good understanding of micro or sub-regional events for a country the size of the US (that would seem to be found in the 'Regional' reserve banks.

In essence you need the Central Bank to actually do this job.

Again, it is rather clear that the Left here is mixing up its unbounded (although not unfounded) dislike bordering on irrational hatred of Greenspan and the appointees of the era of the Bush taint its perception of the Central Bank. The Governor and his Board of the time did indeed fail, although it is very clear from the record the actual regulatory staff was proposing expanded powers, etc. That he rejected, as I recall. But not all the failure rests on Greenspan - it would seem as well no one here bothered to review the list of prime regulators for the failed banks (even allowing the big 3 rescues), the majority of the problem institutions in the US are found outside of the Central Bank regulatory perimeter; a rather clear indictment of the complexity and jerry rigged nature of your system.

capital gain tax advantages are not present.

That observation is not really relevant to the US (and global) housing market bubble, nor the counterparty risks that this aims at. Different issue, different problem.