Friday, 4 July 2014

Regulation Prescience

The big reason why bad regulation is dangerous is because regulatory protocols often have a simultaneous effect on everyone, so their impediments and faults also impinge on everyone. If 500 businesses each make different individual mistakes along the way, the whole sector is not likely to be detrimentally affected. If, however, imprudent regulations hit 500 businesses in the same way then any faults in the regulatory system impinge on the whole sector.
As I've explained before (see "Economic Foolishness" link below), regulatory errors are not benign - in cases like the 2008 financial crisis, they are catastrophic. Have you ever wondered how peculiar it is that so many bankers made the same mistakes in the build up to the crash? Dozens of bankers making dozens of different mistakes wouldn't have brought about the grave dangers associated with what happened - it was the imprudent regulations that facilitated the crash by generating self-similarities in mistake-patterns . Here are a couple of examples unearthed this week by investigators Jeffrey Friedman and Wladimir Kraus.
Regulations like the Basel accords and the US’s recourse rule directed banks to rationalise their preferences from mortgage debt to business debt. Other regulations directed banks to rationalise their preferences towards targeted agencies, which led to the retardation of competitive forces.
Have a look at City A.M’s report and see how closely it resembles what I was saying about the cause of the crisis in this Blog post Economic Foolishness: The Truth About Bankers' Bonuses & Government Subsidies about a year ago - most notably:


1) "The recourse rule – pushed through by the Fed and other regulators – was deliberately designed to steer banks’ funds into CDOs – and it worked a treat. The banks gorged on them. No fewer than 93 per cent of their holdings of mortgage-backed securities were either AAA-rated or were issued by Fannie or Freddie, as stipulated by the regulations; as far as the banks were concerned, they were merely following the new best practice. "

2) Because they owned so many CDOs, retail banks suffered more than any other investors – except investment banks, which packaged mortgages into CDOs and were caught out with stocks of both when the music stopped. The recourse rule only covered commercial banks; hedge funds, insurers and others were not cajoled into buying CDOs. It is clear that the US authorities were therefore not only complicit but also directly responsible for the destruction of the US banking system. Their rule also helped inflate the demand for CDOs, securitisation and even sub-prime mortgages, especially when Wall Street had run out of mainstream mortgages to bundle up.
3) The authors remind us that the crisis was not directly caused by mortgage defaults – rather, it was triggered by a collapse in the market price of CDOs caused by fears about the effect of declining house prices. It was this which decimated balance sheets – not mortgage defaults per se. Had the regulatory system not encouraged retail banks to hold securitised bundles of hard-to-value, opaque CDOs, and instead treated other assets more fairly, the crisis might have been avoided.
4) The 1988 Basel I accords favoured the use of off-balance sheet vehicles such as structured investment vehicles (SIVs), which became huge in the UK and Europe and had a similar effect on the demand for CDOs. By 2006, Basel II began to be implemented outside America; it contained similar incentives to those contained in the recourse rule. The regulatory induced pro-CDO madness had gone global. Needless to say, nobody responsible for these pernicious regulations has been sacked. Bureaucrats, it seems, always get off scot-free.
* Picture courtesy of