{"id":900,"date":"2010-07-13T17:09:58","date_gmt":"2010-07-13T21:09:58","guid":{"rendered":"http:\/\/blogs.darden.virginia.edu\/brunerblog\/?p=900"},"modified":"2013-09-18T15:50:21","modified_gmt":"2013-09-18T19:50:21","slug":"reform-of-the-financial-system-the-limits-to-limits","status":"publish","type":"post","link":"https:\/\/blogs.darden.virginia.edu\/brunerblog\/2010\/07\/reform-of-the-financial-system-the-limits-to-limits\/","title":{"rendered":"Reform of the Financial System: The Limits to Limits"},"content":{"rendered":"

S<\/span>omething there is that doesn’t love a wall,\u2026<\/p>\n

The gaps I mean,
\nNo one has seen them made or heard them made,
\nBut at spring mending-time we find them there\u2026.<\/p>\n

Before I built a wall I’d ask to know
\nWhat I was walling in or walling out,
\nAnd to whom I was like to give offence.
\nSomething there is that doesn’t love a wall,
\nThat wants it down.<\/p>\n

Robert Frost, \u201cMending Wall\u201d<\/a><\/p>\n

Last March, my wife and I took a bicycling trip in southern Arizona.\u00a0 Staying at an inn near the border with Mexico, we climbed up a hill to see The Fence, the barrier that runs along the border.\u00a0 This fence is 15 feet high and consists of vertical steel tubes filled with concrete, quite imposing.\u00a0 But both sides of the fence are littered with empty water bottles, left by immigrants crossing the border.\u00a0 You see, the fence is surmountable with the help of a ladder.\u00a0 More importantly, the fence does not run along the border from sea to shining sea.\u00a0 Some parts of the border aren\u2019t fenced.\u00a0 When we got to the top of the hill, we saw the end of the fence in the middle of the desert.<\/p>\n

U.S. Indian reservations abut the border; the reservations retain just enough autonomy to deny the U.S. government permission to fence their part of the border.\u00a0 One would think that crossing the border at the Indian reservation would be preferable to surmounting the fence.\u00a0 And sure enough, from our hilltop vantage point, we saw a file of 20 or so pedestrians a mile distant snaking their way toward the end of the fence.\u00a0 A momentary transit by a U.S. government helicopter caused the pedestrians to dive under the scrub brush.\u00a0 But my guess is that they weren\u2019t deterred.\u00a0 This impression was confirmed later by some officers from the border patrol.\u00a0 They said that The Fence had slowed, but not stopped, the influx of undocumented aliens.<\/p>\n

The Fence is a metaphor for what we are likely to experience after the likely passage of legislation in the U.S. and Europe<\/a> aimed at tightening regulation of the financial system.\u00a0 Any day now, the U.S. Senate will likely<\/a> vote to approve the \u201cDodd-Frank Wall Street Reform and Consumer Protection Act<\/a>,\u201d which will<\/p>\n

\u00b7\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 allow the Fed to inspect and regulate any institution (bank, hedge fund, insurance company) that is deemed systemically important.\u00a0<\/p>\n

\u00b7\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 \u00a0engineer a smoother process for the government to close down insolvent institutions through a process of orderly liquidation.\u00a0<\/p>\n

\u00b7\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 create the Consumer Financial Protection Agency to fight fraud and abusive financial products and practices. \u00a0<\/p>\n

\u00b7\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 give shareholders an annual, nonbinding \u201csay on pay\u201d for corporate executives.\u00a0<\/p>\n

\u00b7\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 regulate the over-the-counter derivatives market.<\/p>\n

The influential blog, ft.com\/alphaville, opines that<\/a> the legislation might actually help the hedge fund industry by putting a drag on the proprietary trading operations of large financial institutions.\u00a0 \u00a0On the other hand, the swaps and derivatives dealers<\/a> are unhappy with the uncertainty the bill creates around future rule-making, and who will make them.\u00a0 Most importantly, no one is ready to declare that this legislation will forestall the next financial crisis.\u00a0 James Surowiecki, writing in the New Yorker<\/em><\/a>,<\/em> declares that the legislation is no \u201cpanacea.\u201d\u00a0 And Republicans generally have condemned the legislation as an \u201cempty effort<\/a>.\u201d\u00a0<\/p>\n

Doing nothing is not an option: a relatively <\/em>stable financial system is in the public interest.\u00a0 The whole debate, in my view, is around the cost <\/em>of that stability.\u00a0 Imposing regulation on an industry is like buying an insurance policy.\u00a0 A savvy consumer should always ask about the price of the insurance and its effectiveness.\u00a0 Two new books give excellent reviews of the need for regulation and the various proposals.\u00a0 The Squam Lake Report<\/a> <\/em>by Ken French and others condenses the views of leading academic thinkers: it is succinct, dry, abstract, and yet persuasive.\u00a0 French et alia are careful students of the modern financial system, not wild-eyed Tea Partiers.\u00a0 The other book is Crisis Economics<\/a> <\/em>by Nouriel Roubini and Stephen Mihm, two economists\u2014their outlook is edgier, more critical of one and all, and well informed by research, history, and current events.\u00a0 Any reader will find at least something to disagree with in each book.\u00a0 But comparing their discussions to the 2300-page Dodd-Frank Act, one has to conclude that the Act seems to address the important areas of concern.\u00a0<\/p>\n

But think about The Fence.\u00a0 Will the legislation prove to be effective at reasonable cost?\u00a0 We don\u2019t know.\u00a0 Dodd-Frank gives great discretion to regulators to set rules in several important areas.<\/p>\n

1.\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 Transparency.<\/span>\u00a0 In The Panic of 1907<\/em><\/a>,<\/em> Sean Carr and I argued that systemic instability has at its core an information problem: because of complexity in the system and in individual institutions, it is hard for decision-makers to know what is going on and to take effective action.\u00a0 As a result, those decision-makers act out of fear rather than rationality.\u00a0 Thus does a panic begin.\u00a0 As the authors of The Squam Lake Report <\/em>write, \u201cRegulators cannot assess the status of the financial system without knowledge of the intersections between firms.\u00a0 Currently, U.S. regulators do not systematically gather and analyze much of the information outlined above, and the information they do have is often difficult or impossible to aggregate across institutions.\u00a0 This constrains the government\u2019s ability to foresee, contain, and ideally, prevent disruptions to the overall financial services industry.\u201d ((The Squam Lake\u00a0Report<\/em>, page 48))\u00a0\u00a0\u00a0\u00a0\u00a0<\/p>\n

2.\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 Adverse incentives.<\/span>\u00a0 Dodd-Frank does not resolve the huge moral hazard<\/a> created by the government interventions of 2007-2009.\u00a0 Many people supported those interventions on the principle that if your neighbor\u2019s house is on fire, you should help to put it out, lest the fire spread to your <\/em>house.\u00a0 But now we must deal with the legacy of those rescues: creditors may now believe that the government will always rescue them\u2014henceforth will they make riskier loans?\u00a0 \u201cCapitalism without bankruptcy is like Christianity without hell,\u201d said Frank Borman, CEO of Eastern Airlines in the 1980s.\u00a0 Will market participants devoutly observe sensible practices if there are no consequences?<\/p>\n

3.\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 Global linkages.<\/span>\u00a0 The Act considers financial enterprises in the U.S.\u00a0 But the potential sources of instability extend well beyond our borders.\u00a0 Nouriel Roubini and others have explored the possibility of establishing a global regulator of financial institutions; but no country seems particularly willing to give up sovereignty to achieve the kind of comprehensive regulation that would be required.\u00a0 If you want my nomination for the \u201cEnd of The Fence,\u201d this is it.\u00a0 Asymmetries in the ways countries regulate the financial services industry will stimulate \u201cregulatory arbitrage.\u201d<\/p>\n

4.\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 Executive compensation.<\/span>\u00a0 An annual, nonbinding \u201csay on pay\u201d vote by shareholders may well focus attention on the wrong aspect, the level of executive compensation.\u00a0 Instead, the recent bubble and financial crisis were rooted in the heads-I-win-tails-you-lose payoffs embedded in the bonus compensation plans of some financial institutions.\u00a0 The market for talent should dictate the level of compensation.\u00a0 Let traders and managers be rewarded for excellent performance; but why not let their bonuses be paid in deferred compensation so that they must bear the longer-term consequences of their actions?\u00a0 It may be that regulators will start to dictate the structure of bonus schemes.<\/p>\n

5.\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 Institutions.<\/span>\u00a0 The legislation does not address the failures at Fannie Mae and Freddie Mac, institutions that formerly operated with an implicit government guarantee and were taken over by the government in 2008.\u00a0 Henry Paulson, interviewed in today\u2019s New York Times<\/em><\/a>,<\/em> said, \u201c\u201cThe root causes of all this are housing policies \u2014 not just Fannie and Freddie,\u201d he said, referring to the giant mortgage companies. \u201cThat hasn\u2019t been dealt with.\u201d\u201d\u00a0 The Act does address the credit rating agencies, though the regulations may be too little, too late.\u00a0 William Gross, the iconic investment manager and co-founder of PIMCO said<\/a> that the NRSROs\u00a0 “\u2019no longer serve a valid purpose for investment companies free of regulatory mandates\u2019 and urged investors to dismiss their judgments.\u201d\u00a0<\/p>\n

6.\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 Too big to fail. <\/span>\u00a0\u00a0The Act takes no position on busting up banks that are so big that their failure would endanger the stability of the financial system.\u00a0 But the Act implicitly defers to the regulators\u2019 powers to dictate reserve requirements and require the orderly dissolution of insolvent banks.<\/p>\n

Any fence has its own limitations.\u00a0 On many of the items listed above, Dodd-Frank grants significant rule-making discretion to regulators.\u00a0 In one respect, it is fortunate that Congress chose not to micro-manage an incredibly complex system. \u00a0\u00a0Even Barney Frank told NPR<\/a> today, \u201c”If you do it too inflexibly, you’re inviting the businesses to get around you. You need to give the regulators discretion. And people said, ‘What’s the guarantee that this discretion bodes well?’ And the answer is: In democracies, there are no guarantees. Elect good people.\u201d<\/p>\n

Might those regulators themselves become victims of \u201cregulatory capture<\/a>,\u201d the co-opting of regulators by those they must regulate?\u00a0 Much of the mentality of successful entrepreneurs and business people is aimed at surmounting obstacles in order to grow a business and fulfill its mission.\u00a0 They will accept the laws and regulations as a constraint and then optimize within and around those bounds.\u00a0 But the bounds are bounded: the regulations cannot anticipate the ingenuity of business people in the future.\u00a0 I have sounded similar concerns before (see this<\/a>, this<\/a>, this<\/a>, and this<\/a>.)\u00a0<\/p>\n

Above all, this legislation will not \u201cfix\u201d the problem of panics, crashes, and financial system instability.\u00a0 The authors of The Squam Lake Report <\/em>suggest that there may be no \u201cfix\u201d: \u201cThe economic hardships triggered by the World Financial Crisis have caused government officials and citizens around the world to demand regulatory reforms that will prevent financial crises.\u00a0 There is no reasonable way to accomplish this goal.\u00a0 Financial crises have recurred throughout modern history.\u00a0 \u2026We expect that financial crises will continue to happen for centuries into the future.\u00a0 Our goal is not to prevent such crises but to reduce their frequency and severity.\u201d ((The Squam Lake Report <\/em>pages 149-150))\u00a0 Similarly, Roubini and Mihm wrote, \u201cFar from being the exception, crises are the norm, not only in emerging but in advanced industrial economies.\u00a0 Crises\u2014unsustainable booms followed by calamitous busts\u2014have always been with us, and with us they will always remain.\u201d ((Roubini and Mihm, Crisis Economics <\/em>page 4))<\/p>\n

It is said that most dieters successfully lose some pounds\u2014and eventually regain them.\u00a0 For a person to shed weight and keep it off requires not merely the gimmick of the diet, but actually a transformation of one\u2019s lifestyle, an internal discipline, a wall<\/em>.\u00a0 Most dieters aren\u2019t willing to give up the way they used to live: too much food, too little exercise.\u00a0 They circumvent the wall.\u00a0 Like the overweight dieter, America is carrying too much debt, is running a negative trade balance, has huge fiscal deficits, and hopes that the dollar will continue to be the stable reserve currency of the world.\u00a0 The Dodd-Frank Act may have some modest impact on our national health.\u00a0 But in order for us to avoid the kind of financial instability we\u2019ve just lived through, we\u2019ll have to change our lifestyle: save more, consume and import less, retire later, and for a while, endure more unemployment and perhaps pay more taxes.\u00a0 Whether Americans have the discipline for this is the main question.\u00a0 Something there is that doesn\u2019t love a wall.<\/p>\n","protected":false},"excerpt":{"rendered":"

Something there is that doesn’t love a wall,\u2026 The gaps I mean, No one has seen them made or heard them made, But at spring mending-time we find them there\u2026. Before I built a wall I’d ask to know What I was walling in or walling out, And to whom I was like to give […]<\/p>\n","protected":false},"author":18,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"_monsterinsights_skip_tracking":false,"_monsterinsights_sitenote_active":false,"_monsterinsights_sitenote_note":"","_monsterinsights_sitenote_category":0,"footnotes":""},"categories":[58345,59206],"tags":[754,756,758,752,755,751,753,759,757,714,346],"class_list":["post-900","post","type-post","status-publish","format-standard","hentry","category-economic-crisis","category-finance-2","tag-arizona","tag-consumer-financial-agency","tag-crisis-economics","tag-financial-system","tag-government","tag-reform","tag-robert-frost","tag-tha-panic-of-1907","tag-the-squam-lake-report","tag-university-of-virginia-darden-school-of-business","tag-uva"],"acf":[],"yoast_head":"\nReform of the Financial System: The Limits to Limits - Robert F. Bruner<\/title>\n<meta name=\"description\" content=\"July 13, 2010 - Something there is that doesn't love a wall,\u2026 The gaps I mean, No one has seen them made or heard them made, But at spring mending-time we find them\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/blogs.darden.virginia.edu\/brunerblog\/2010\/07\/reform-of-the-financial-system-the-limits-to-limits\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Robert F. 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