The Myth of Regulating Finance.

• Author: Ezrati, Milton

Today's financial markets will inevitably suffer another crash. It might come soon, especially if recent inflation proves to have more staying power than the authorities suggest. But even if markets escape trouble in the immediate future, wild swings are an unavoidable feature of financial markets. Nor can any reasonable regulation guard against them, certainly not those Washington put in place after the last crisis. Regulation is simply inadequate to the task.

The only taming mechanism that might work would so tighten regulatory control that the United States would lose much of the contribution finance makes to the nation's prosperity and economic development, a cure worse than the disease. Since governors from the past--gold and fiscal discipline, for instance--have little practical application today, a best solution, perhaps the only one, would keep regulations as a moderator but admit that the goal of control lies beyond our reach, that severe risks remain present always. Perhaps such a sense might instill in financial management more prudence than it has shown in some time, enough at least to ameliorate boom-bust tendencies. Such a sense and the caution it instills among financial players has done so at times in the past.

The regulatory approach did little to prevent the crash in 2008-09. Dodd-Frank regulation did not exist at the time, but several authorities--the Federal Reserve (the Fed), the Comptroller of the Currency, and state regulatory bodies in this country; the Bank for International Settlements (BIS) in Basel, Switzerland, internationally, and equivalents in most other countries--imposed regulations to guard against financial excess and collapse. Yet all their rules failed to stop the preceding boom and that terrifying collapse. When the investment bank and broker-dealer Bear Stearns revealed problems and began the crisis early in 2008, the firm was in full compliance with all regulations. It was fully solvent by all the most up-to-date accounting standards. Nonetheless, it was unable to meet all its immediate trading obligations. Almost as an admission that the regulations were inadequate, the authorities tried to control events by immediately reaching outside regulatory structures. They forced Bear Stearns to sell itself at a bargain price to J.P. Morgan--a preemptory move that may in retrospect have created more uneasiness among investors than it alleviated.

Even though all major financial institutions had adhered to existing regulations, the financial crisis got worse before it got better. At each stage in the collapse, the authorities met the challenge of the moment by moving outside their own regulatory structures. Ultimately, the Treasury Department put billions of taxpayer dollars at risk, lending to financial institutions through what it called the Troubled Asset Relief Program. The Fed and other central banks brought lending rates around the world down to inordinately low levels, near zero in fact, and found novel ways to make billions in financial liquidity available to otherwise failing banks and other financial institutions. The authorities forced sales, made extraordinary loans, took over financial firms, and let others go bankrupt in the process. If this jerry-rigged approach did not exacerbate the panic, it certainly confirmed the feeling at the time that no one had control. More than anything else, the extraordinary measures pointed up the inadequacy of the regulations.

Following the crisis, Washington set out to put safeguards in place largely by doubling down on the regulatory approach that had just failed. Though the details of their new rules are even more complex than the old, they mostly just strengthen what had previously existed. The BIS' latest set of guidelines, for example, under the heading Basel IV to distinguish them from the old Basel II and III rules, deals with the problem by stipulating that banks should set aside a total of some 8 percent in capital of various kinds, depending on the risk of their asset mix. This emergency capital is typically held in very safe repositories, government debt or deposits at the central bank, where the financial institution can draw on it quickly and reliably to meet obligations when the normal course of business fails to do so. The Dodd-Frank financial reform in the United States essentially has done the same. It includes two additional noteworthy measures. It singles out larger institutions where failure might threaten the financial system, designates them "too big to fail," and imposes on them especially stringent capital requirements. It also stipulates that these institutions undergo periodic "stress tests" to see how much financial trouble they could withstand.

These new, more stringent, and intrusive rules may provide some safeguards. They may help the regulators--and the public--feel more secure. They may even give comfort to people involved in finance. At bottom, however, they, like the old rules, are chimerical. At least three reasons...