Reading the future of financial regulation

Read our article in the Cayman Financial Review Magazine, eversion 

The financial crisis has spawned a massive literature, a substantial
part of which concerns the authors’ favoured ways to prevent the next
crisis. 
 

Much like Friedman and Kraus, CFR contributor Birgir Petursson and I focus on regulators’ capacity in our paper, ‘Global Economies, Regulatory Failure & Loose Money: Lessons for Regulating the Finance Sector from Iceland’s Financial Crisis’.  Unlike them, we use Iceland as an example.

The first place to start thinking about such a sprawling topic is with Carmen Reinhart and Kenneth Rogoff’s masterpiece, ‘This Time is Different: Eight Centuries of Financial Folly’ (Princeton University Press 2009).

The book’s analysis is built “around data culled from a massive database that encompasses the entire world and goes back as far as twelfth-century China and medieval Europe”. Loaded with tables and graphs (a feature that makes my economist’s heart race), it replaces the narrative approach of earlier surveys (like Charles Kindleberger’s superb ‘Manias, Panics and Crashes’ (1989)) with a data-driven analysis.

Their most important conclusion is that “the most commonly repeated and most expensive investment advice ever given in the boom just before a financial crisis stems from the perception that ‘this time is different’.

That advice, that the old rules of valuation no longer apply, is usually followed up with vigour. Financial professionals and, all too often, government leaders explain that we are doing things better than before, we are smarter, and we have learned from past mistakes.” Sadly, none of this has proven true thus far. This time is different? The authors conclude “It almost never is”.

Having sobered oneself with Reinhart and Rogoff’s conclusion, next dive into ‘The Financial Crisis Inquiry Report’ by the National Commission on the Causes of the Financial and Economic Crisis in the United States (Public Affairs 2011).

At over 600 pages, the somewhat dry prose will both serve as an anti-insomnia aid for an extended period and help hold down papers in a windstorm. Although the Commission report is short on details of the proposals for change, a careful read of the six member majority report (410 pages) will show the direction future financial regulations are likely to take: more regulations and more aggressive regulators.

The really interesting bits are in the two dissenting statements at the end. Keith Hennessey, Douglas Holtz-Eakin and Bill Thomas point (correctly in my view) to international issues that the majority ignores.

In the text in the Public Affairs edition, dissenting commissioner Peter Wallison points out deep flaws in the process by which the commission reached its conclusion and focuses on the mortgage problem. Wallison is one of the most perceptive commentators on financial regulatory issues in the US and his views are well worth the investment of effort to get in full.

The complete version of his dissent is in the Government Printing Office version (available for free at http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf). Particularly important is the question Wallison asks at the beginning of his dissent: why did Congress bother to have a Financial Crisis Commission at all, given that it did not wait for the report before crafting and passing the Dodd-Frank Act?

Turning to the academy, ‘Restoring Financial Stability: How to Repair a Failed System’ (Viral V Acharya & Matthew Richardson, eds, Wiley 2009) provided the first, and still among the best, road maps for regulatory reform from academics.

A collection that emerged from a group of faculty at the NYU Stern School of Business in 2007-2008, this collaboration yielded careful, thoughtful first takes on regulatory proposals. A trifle dated, it remains among the most comprehensive and thoughtful takes on possible regulatory reforms.

From the world of people doing finance instead of studying it, comes Robert Pozen’s ‘Too Big to Save? How to Fix the U.S. Financial System’ (Wiley 2010). Since Pozen has been a regulator at the SEC and a key player in finance at MFS Investment Management and Fidelity Investments, as well as a lecturer at the Harvard Business School, he has a somewhat different perspective than the pure academics.

Pozen focuses largely on market failures and how to correct them, although he does promote measures to reduce barriers to international trade. Much like government regulators, he also leaps from problem to problem, with little attention to ensuring consistency of approach across different areas. The book’s catalogue of policy proposals will seem like a candy store to the average regulator or legislator, so it is well worth reading to see what sorts of goodies are likely to be on offer.

To jolt yourself out of conventional wisdom, the brief (156 pp) ‘Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation’ by Jeffery Friedman and Wladimir Kraus, both associated with the journal Critical Review, points the finger at the Basil Accords as the cause of the crisis. It then goes on to raise serious questions about the ability of regulators to foresee and cope with the problems that cause financial crises.

Their critiques of the standard theories (Fannie Mae/Freddie Mac, deregulation, excess leverage etc) are thought-provoking; their analysis of regulators’ capacities is relevant to any discussion of what to do to make it different next time.

Finally, to get a sense of what regulators should, but won’t, do, read John Taylor’s ‘First Principles: Five Keys to America’s Prosperity’ (Norton 2012). Admirably concise, like his excellent ‘Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis’ (Hoover Institute 2009), First Principles argues that policy makers ought to follow a set of basic economic principles.

In Getting Off Track, Taylor showed the impact of the Fed’s monetary policy decisions in causing the financial crisis. In Global Financial Warriors (Norton 2007), he described his experiences as an academic in the policy world. (Taylor served as a Undersecretary in the Treasury Department under George W. Bush.)

In First Principles he draws on both his academic background and his time in the Washington trenches to reject efforts to impose complex solutions (eg Dodd-Frank) and instead emphasises getting the fundamentals right.

Since that offers far fewer opportunities for graft, influence-peddling and corruption, don’t expect policymakers in Washington, London, Brussels or elsewhere to be paying attention.

 

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Andrew P. Morriss

Andrew P. Morriss, Chairman, is the D. Paul Jones, Jr. & Charlene Angelich Jones – Compass Bank Endowed Chair of Law at the University of Alabama School of Law. He was formerly the H. Ross & Helen Workman Professor of Law and Business at the University of Illinois,Urbana-Champaign. He received his A.B. from Princeton University, his J.D. and M.Pub.Aff. from the University of Texas at Austin, and his Ph.D. (Economics) from the Massachusetts Institute of Technology. He is a Research Fellow of the N.Y.U. Center for Labor and Employment Law,and a Senior Fellow of the Institute for Energy Research, Washington,D.C., as well as a regular visiting faculty memberat the Universidad Francisco Marroquín,Guatemala. He is the author or coauthor of more than 50 scholarly articles, books, and bookchapters, including Regulation by Litigation (Yale Univ. Press 2008) (with Bruce Yandle and Andrew Dorchak), and is the editor of Offshore Financial Centers and Regulatory Competition (American Enterprise Institute Press 2010).

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