Bad Regulations Caused This Crisis

Political Calculations provides a great case in point for my skepticism over regulations and regulators. The greatest problem with regulations is their unintended consequences.

An FDIC document on the risk weights of different bank assets. The higher the weight, the more capital the bank has to hold against that asset. As I read table 1 and table 3, if you originate a loan with a down payment of 20 to 40 percent, the risk weight is 35. But if you buy a AA-rated security, the risk weight is only 20. So if a junk mortgage originator can pool loans with down payments of less than 5 percent, carve them into tranches, and get a rating agency to rate some of the tranches as AA or higher, it can make those more attractive to a bank than originating a relatively safe loan. If you want to know why securitization dominated the mortgage market, this explains it. Regulatory arbitrage, pure and simple.

And the greatest problem with regulators is that they often do not act until it is too late. Regulators do not respond well to new technologies and new innovations because they are entrenched in a bureaucracy with a well-worn mode of operation. Going outside the box will put a regulator's job in jeopardy if he is wrong or at the very least, cause his actions to be examined. And if you have a cushy job, why rock the boat and put your generous benefits in danger? If all goes to hell, regulators can always just use the age old excuse that they don't have enough resources or that they need new powers and new regulations to do their job correctly.

I've heard too many people expressing a wish for more regulations recently, without any regard as to how these regulations will work and how they will be structured. We need more good regulations, but that's easier said than done. It's crucial we do not make more bad regulations and most of all, we cannot expect regulators to do a better job than they've done in the past. You can't expect a lifelong C student to become an A student. We have to factor in incompetence. Only then can we determine if the regulation is likely to do more good than harm. So far, only the good part is being examined, with nothing on the harm that regulations routinely inflict.