Mark Kleiman (hat tip Brad DeLong) says more clearly what I tried to say a while back: cost-benefit analysis of regulations has a curious way of nailng the costs and underestimating the benefits. He focuses on three points:
- Traditional CBA counts all dollar benefits equally, despite the fact that the marginal utility of a dollar depends a lot on who is getting it; a dollar more for a poor person provides a lot more utility than a dollar more for a rich person.
- Long-term or uncertain benefits, no matter how large (like preventing the inundation of every coastal city) are typically discounted down to zero.
- Benefits that are difficult to quantify because there is no market for them (like feeling better because you are healthy) never get counted. (This is the one I know best because it’s one of the things my wife specializes in.)
Matt Yglesias also comments.
By James Kwak
We received the following email from James Coffman in response to Bond Girl‘s recent guest post, “Filling the Financial Regulatory Void.” Coffey agreed to let us publish the email. As he says below, he spent 27 years in the enforcement division of the SEC.
Bond Girl’s “Filling the Financial Regulatory Void” provided insight into human deficiencies in the current financial regulatory system. But it overplays the human failings of regulators and concludes with a proposed solution that, in all likelihood, would turn out worse than the current situation. But first, in the interest of full disclosure, I should tell you that I retired two years ago from a management position in the enforcement division at the SEC after 27 years. So I was (and in my heart, I suppose I still am) a financial regulator. That background probably should be taken into account by anyone who reads this response.
There is no doubt that “regulatory capture” exists and is a meaningful factor in the recent failures of our regulatory system. Many of us in the enforcement division dealt with the problem regularly when we sought input from those in the agency who were responsible for regulating aspects of the securities markets. Over time, regulatory policies and practices had emerged that seemed to contradict the purpose if not the letter of the law. In other cases, over-arching issues (e.g., increases in fees charged by investment companies despite growth that should have resulted in economies of scale and decreasing fees) simply were not addressed in any meaningful way.
Felix Salmon has a good example of why disclosure (the preferred consumer-protection regime of free-market conservatives and bankers) doesn’t work, courtesy of Ryan Chittum. The topic is no-interest balance transfers offered by credit card companies.
As Salmon points out, most people probably realize what the game is. That is, most people know that banks aren’t in the business of lending money for free; they know that the bank is betting that it can raise the interest rate before they pay off the balance. It’s possible that you will end up getting a free loan: “If you’re smart and disciplined and lucky, you might be able to game the system and pay no interest at all on that balance. Bank of America, for its part, does its very best to make you think that you’ll be able to do just that, essentially getting one over on The Man.” But the bank knows it has the numbers on its side; and most consumers know it too, because they know that’s the only reason the bank would make the offer.
This guest post was contributed by Ilya Podolyako, a recent graduate of the Yale Law School, where he was co-chair of the Progressive Law and Economic Policy reading group with James Kwak.
The development of the news coverage of high-frequency trading has been quite interesting. The story started out with a criminal complaint that Goldman Sachs lodged against Sergey Aleynikov, a former employee who allegedly stole some secret computer code from the Goldman network before departing for a new job in Chicago. Incidentally, Mr. Aleynikov appeared to be headed to Teza Technologies, a company recently started by Mikhail Malyshev, who had previously been in charge of high frequency and algorithmic trading at Citadel, a Chicago-based hybrid fund. Immediately after the report leaked, Citadel began investigating Mr. Malyshev’s departure and filed a lawsuit to prevent him from getting his nascent business off the ground. From these facts, some reporters inferred that the surprisingly public maneuvers of two notoriously secretive finance giants vis-à-vis seemingly routine personnel matters showed that Aleynikov had tapped into the gold mine of precious proprietary trading software.
That was two weeks ago. At this point, the story has crescendoed. The New York Times ran a report on high frequency trading. The Economist published a piece on the same topic. Senator Schumer (D-NY) requested that the SEC investigate the matter and the agency acquiesced.
The cynical perspective on these events is that both Schumer’s and Mary Schapiro’s moves with respect to algorithmic trading show that the issue is a red herring. As the argument goes, neither of these actors would touch the practice if it actually underpinned Goldman’s record profits or Citadel’s outstanding performance in 2004-2006. If, however, banning the practice would eliminate a few small hedge funds and create the appearance of revising market frameworks without threatening the big players (a regulatory brush fire of sorts), high-frequency trading would form the perfect political target.
As Simon pointed out earlier, Jamie Dimon has been getting a lot of good press recently. The New York Times portrayed his recent rise to prominence as not only the CEO of American’s number one bank (at least, the number one bank that has not recently been compared to a vampire squid), but as a player in Washington and, according to at least one quip, the man Barack Obama turns to on financial questions:
Now that Mr. Obama is in the White House, Mr. Dimon has been prominent when the president wants to talk to big business.
During one such meeting in late March, as Citigroup’s chairman, Richard D. Parsons, was trying to explain banks and lending, the president interrupted with a quip: “All right, I’ll talk to Jamie.”
Peter Wallison of the American Enterprise Institute accuses the Consumer Financial Protection Agency of being a liberal plot to restrict good financial products to sophisticated elites. Mike at Rortybomb does a point-by-point takedown complete with actual data, so I can stick to the high level (not to be confused with the high road).
Wallison’s op-ed reads like a caricature of conservative ideology – all supposed moral principle and no real-world implications. His argument is basically that by imposing restrictions on complex products (Option ARM mortgages) that are not imposed on plain vanilla products (30-year fixed-rate mortgages), the CFPA is limiting choice for the poor and unsophisticated and preserving choice for the rich and sophisticated; since according to conservative ideology choice is always good in principle, the CFPA is discriminatory.
Where do we start?
Justin Fox says that financial regulation should be simpler and should give less discretion to regulators.
The argument goes like this: the biggest flaw in current financial regulation is not that there is too little of it or too much, but that it relies on regulators knowing best. We regulate because financial systems are fragile, prone to booms and busts that can have harmful effects on the real economy. But regulators aren’t immune to the boom-bust cycle. They have an understandable habit of easing up when times are good and cracking down when they’re not.
As I’ve said before, the Obama Administration’s plan is likely to give us more sophisticated regulation, but if it doesn’t give us more powerful regulators with more incentive to stand up to the industry, all the sophistication in the world won’t matter. Regulators didn’t use the tools they had – the Fed could have policed risky mortgages (and raised interest rates), the bank regulators could have insisted on higher capital requirements, etc. – because they lacked the motivation to use them in the face of overwhelming opposition from the banking industry and, probably, the power to resist Congress and the administration, whichever party controlled them.
As Ezra Klein puts it: “When evaluating a particular financial regulation proposal, ask yourself this question: Would these regulations have worked if Alan Greenspan hadn’t wanted to implement them?” That’s a good question, although it’s a bit unfair: if you posit a regulator who doesn’t believe in regulation, then virtually any regulatory scheme is bound to fail. This is why Fox and Klein argue for ironclad rules that don’t leave room for discretion. In addition, though, I think we also need to think about how to make sure we get regulators who are not cheerleaders for or captives of the financial services industry.
By James Kwak
I originally published this post over at The Hearing on Monday, but it feels more like a Baseline Scenario kind of post.
One part of the Obama Administration’s financial reform plan is tighter regulation of credit default swaps – those previously unregulated derivatives that brought down AIG and nearly the entire financial sector with it. One of the problems with AIG was that its regulators were apparently unaware that it had amassed a huge, one-sided portfolio of credit default swaps that amounted to a massive bet the economy would do just fine; another problem was that, because credit default swaps were “over the counter,” custom transactions between individual private parties, they created a large amount of counterparty risk – the risk that the party you were trading with might not be there to honor the trade.
In response, the administration proposes to “require clearing of all standardized OTC derivatives through regulated central counterparties (CCPs).” In addition, “regulated financial institutions should be encouraged to make greater use of regulated exchange-traded derivatives.” Major players in the market will also be subject to conservative capital requirements (making sure they have enough money in case their trades go badly) and reporting requirements. These provisions aim to increase regulatory oversight and minimize the chances that a derivatives dealer will fail and take its counterparties down with it, and as far as they go they are a good thing.
However, there is one potential loophole that, according to UCLA law professor Lynn Stout (on Friday’s Morning Edition), is “potentially big enough to put the state of Texas into.” The loophole is that “customized bilateral OTC derivatives transactions” would remain out of the reach of both exchanges and CCPs.
We’ve had TARP for banks, TARP for auto companies, and now, with the Obama Administration’s plan for financial regulatory reform, we have TARP for regulators. After AIG, Citigroup, Bank of America, and General Motors, the administration has decided that all the existing regulators are Too Big to Fail – except for the Office of Thrift Supervision, which must play the role of poor Lehman Brothers in this saga. (Actually, they are more like Merrill Lynch, since they are getting merged into the new National Bank Supervisor, so most of them will probably keep their jobs.)
There is actually a serious issue here, and one with no obvious solution. One question that has gotten a lot of ink, both before and after the unveiling of the plan yesterday, has been the identity of the systemic risk regulator: new agency? council of agencies? the Fed? What this really shows is that it’s easier for the media, the administration, and Congress to focus on the how the agency acronyms will be reshuffled, which is a bit like covering a sporting event, than on the underlying issues, like how to make those agencies more effective.
Barack Obama came to office as the conciliator, the bipartisanizer, the anti-Bush. But this is going too far.
The administration’s style has been to float policy proposals in public, listen to the responses (from other politicians, from the private sector, and from the blogs that Obama does not read), and adjust accordingly. When it comes to the financial regulation proposal that Tim Geithner is scheduled to deliver on Thursday, there may be little left after all the adjusting.
Tim Geithner will be testifying before both Senate and House committees next Thursday on the administration’s proposal for financial regulation. In the meantime, there will be a lot of talk about financial regulation.
The Wall Street Journal (subscription required) and Washington Post (subscription not required) have been reporting on how the administration’s plans have been “pared back.” Those articles mainly dwell on the likelihood that the administration will not try to abolish and consolidate agencies as had once been thought possible (although OTS and OCC may be merged). This is interesting, given that Larry Summers just said that eliminating regulatory arbitrage was one of his key principles.
Tyler Cowen has some intelligent thoughts on why consolidation may not be such a great idea. My feeling is that consolidation could be good insofar as the current situation is clearly bad. I agree with Felix Salmon:
The current regulators have clearly failed at their jobs, there’s no reason for entities like the OCC and the OTS to continue to exist, and it’s worth remembering at all times that the number of large American financial-services companies with intelligent and sophisticated and effective regulation is, currently, zero.
Fresh Air had an excellent interview with Georgetown law professor Adam Levitin, who blogs here. It’s only 21 minutes and I recommend it if you are interested in credit cards or in financial regulation in general.
Credit cards are an interesting if perhaps extreme case of the interplay between “innovation” and regulation in the financial industry. A long time ago, someone invented the credit card. This was a real, beneficial innovation, because it allowed people to make medium-sized purchases on credit. (You could already buy a house on credit, if you put 30% down.) Let’s say that without credit, it would take you nine months to save enough money to buy a refrigerator. Now you could buy the refrigerator and then save the money; it might take you ten months with the interest, but you get to use the refrigerator for that whole time. (A refrigerator could also save you money, because it might allow you to go shopping less often, buy in bulk, and eat at home more.) All good so far.
Note: After writing this, I read Brad DeLong’s better review of Posner’s book (hat tip Felix Salmon). I won’t be offended if you go read that instead.
Part I of my comments on Richard Posner’s epic blog discussed the concept of blame. Today I am going to discuss his approach to some policy questions.
Posner’s crisis book is boldly titled “A Failure of Capitalism.” The problem is that when the lens through which you see the world is capitalism – or, more precisely, a flavor of economics that works out to justify capitalism in virtually every instance – it’s not clear what’s left over when capitalism fails.
Posner’s method is simple, and I can do it, too. Basically, for any policy, extrapolate out its effect until you can demonstrate that it will lead to a bad (and preferably non-intuitive) outcome – typically by changing the incentives for rational actors so that they no longer maximize profits and thereby social utility. When you do this enough, it becomes such second nature that you forget to spell out your arguments. Here’s a simple example:
While cramdown would have benefited some homeowners, it would have hurt lenders and thus have undermined the bank bailouts.
That’s the whole argument. Filling in the blanks, Posner is saying that because you have decided (a) to bail out banks, you cannot undertake another policy (b) - which may have its own costs and benefits – because it is in some way contrary to policy (a).
For a complete list of Beginners articles, see Financial Crisis for Beginners.
Arnold Kling helpfully pointed out a 2000 paper on regulatory capital arbitrage by David Jones, an economist at the Fed. In his post, Kling said, “In retrospect, this is a bit like watching a movie in which a jailer becomes sympathetic to a prisoner, when we know that the prisoner is eventually going to escape and go on a crime spree.” Having finally read the paper, I have little to add in the way of analysis. But I thought it provided a useful basis for a discussion of what regulatory capital arbitrage (RCA) is and why it is a helpful way of thinking about the financial crisis.