This is no way to make your point about deregulation. Attempting to apply supply and demand logic to the issue of fire protection is absurd. It does not make the point you want it to make at all.

Financial regulation and safety are two completely different issues.

Tuesday, November 4, 2008

“He calls for a regulatory system based on “principles” rather than “rules.”

Via Deal Book on the NY Times we get “Stephen Schwarzman’s Seven-Step Program”:

“In an opinion piece in The Wall Street Journal’s Nov. 4 issue, Mr. Schwarzman maps out seven principles he believes should guide any regulation of the financial system. In many of them, he uses the opportunity to criticize the current regulatory framework in the United States, describing a “hodgepodge” of fragmented agencies and laws that make a “fetish of compliance with complex regulations.” He expresses concern that the latest debacle on Wall Street will inspire a thicket of new rules that choke off innovation.”

Here’s my comment:

“He calls for a regulatory system based on “principles” rather than “rules.” He writes:

If we are to sweep a vast array of financial institutions into the net of a single regulator, then that regulator has to be able to regulate not by promulgating a blizzard of ever more complex rules, but by enunciating a set of guiding principles. If these principles are coupled with strong disclosure and oversight, they will give the regulator the flexibility needed to cope with an ever-changing financial landscape, and to provide a clear direction for the regulated institutions.”

I agree with this:

This is the real problem with regulation. These investors can be very clever people, and are adept at shifting the terrain. That’s why regulation always seems to be correcting the last problem.

The solution is either to regulate or supervise risk, especially any investment that shifts risk to a third party or magnifies risk. In other words, broad principles.

However, have you ever noticed that some of these recommendations being bandied about are as simple disclosure and transparency, traits one would think a decent human being would try and exemplify as a matter of course.

— Posted by Don the libertarian Democrat

“The dismissive response, Mr. Lo said, was not really surprising because Wall Street was going to chase profits in the good times. The path to sensible restraint, he said, will include not only better risk models, but also more regulation. Like others, Mr. Lo recommends higher capital requirements for banks and the use of exchanges or clearinghouses for the trade of exotic securities, so that prices and risks are more visible. Any hedge fund with more than $1 billion in assets, he added, should be compelled to report its holdings to regulators.

Financial regulation, Mr. Lo said, should be seen as similar to fire safety rules in building codes. The chances of any building burning down are slight, but ceiling sprinklers, fire extinguishers and fire escapes are mandated by law.
“We’ve learned the hard way that the consequences can be catastrophic, even if statistically improbable,” he said.”

The recommendations made are fine:
1) higher capital
2) a clearinghouse
3) better regulation

I’ve already agreed with and talked about all of them. However, the regulations need to be based on human agency and not simply measurable factors. That’s why I believe only simple and broad principles can work in this forthcoming regulation. Otherwise:

“Innovation can be a dangerous game,” said Andrew W. Lo, an economist and professor of finance at the Sloan School of Management of the Massachusetts Institute of Technology. “The technology got ahead of our ability to use it in responsible ways.”

This is just another way of saying that if the regulations are too specific, investors will find a way around them. You need a set of principles that can funnel riskier investments into a screening process where they can be examined. The actual amount of government regulation should be based on that assessment. Unfortunately, that will be done by human agency, and has its own set of conditions and risks. There’s no simple answer.