Obama’s financial speech and the great regulation quandary

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So, long after Ana got to it on Swampland, I’ve finally read Barack Obama’s big financial regulation speech. His basic diagnosis of the problem is this:

A regulatory structure set up for banks in the 1930s needed to change because the nature of business has changed. But by the time the Glass-Steagall Act was repealed in 1999, the $300 million lobbying effort that drove deregulation was more about facilitating mergers than creating an efficient regulatory framework.

Since then, we have overseen 21st century innovation – including the aggressive introduction of new and complex financial instruments like hedge funds and non-bank financial companies – with outdated 20th century regulatory tools.

So far, so good. But what would 21st century regulatory tools look like?

Obama’s suggestions read like a somewhat bolder version of the recommendations put out a couple of weeks ago by the Hank-Paulson-run President’s Working Committee on Financial Markets. They basically amount to making financial regulation more consistent across different kinds of institutions, and, uh, doing a better job of catching problems before they turn into crises.

That first part, which would one hopes involve consolidating the current alphabet soup of financial regulatory agencies, is undeniably a good idea and seems to be gaining support from across the political spectrum–although it will be fiercely opposed by most of the regulators themselves, and by the different financial sectors that each likes having its own semi-captive overseer.

But expecting even better-organized regulators to nip emerging financial problems in the bud is unrealistic. It’s not as if the UK’s Financial Services Authority–which combines the regulatory (but not the monetary) powers of the Fed with those of the SEC, the OCC, the OTS, the FDIC, and the CFTC–has done such a great job either.

As Gillian Tett writes in today’s FT:

During most of this decade, the financial industry has placed a near-religious faith in the idea that distributing credit risk (via securitisation, for instance) made banking safer. Moreover, bankers and policymakers have also taken it as gospel that innovation was an inherently good thing – implying, in turn, that the best regulatory regime has a light touch.

In retrospect, it is clear that this philosophy has been dangerously self-serving for the banks, prompting them into a perilous orgy of greed. However, in practice, it has been extremely hard for anyone to challenge the dominant gospel in recent years – be they a journalist, a politician or supervisor.

FSA supervisors tend to be former bankers, or drawn from the same intellectual and academic background. Moreover, they have increasingly succumbed to a “silo” mentality.

In particular (and as this week’s report notes) supervisors have been trained to spend their time ticking boxes, within their allotted silos, rather than take a holistic view of risk. FSA supervisors, in other words, were neither equipped nor authorised to challenge the gospel of securitisation, in respect of Northern Rock or anything else.

Tett suggests that higher pay for FSA regulators, plus more recruitment of non-bankers, might improve matters. But those seem like pretty paltry changes. The reality is that it’s incredibly hard for anybody, be they regulator or CEO, to stand in the way of a financial innovation that’s churning out big profits. The only things that can stand in the way are outright bans on innovation of the sort that emanated from Congress and regulators during and after the Great Depression. But Obama himself says in his speech that he doesn’t want to go back to that kind of regulation.

This isn’t a criticism of Obama. It’s the basic quandary at the heart of all today’s discussions about fixing financial regulation. What we dream of is a wise, disinterested regulator that somehow combines a light touch with an iron fist. And we’re never going to get that. So what’s the second-best option?

Update: Just to be clear on something that Terrapinion brings up in the comments, I think that 95% (or maybe it’s 99%, or 93.732%) of “financial innovation” amounts to either:
1) Putting old wine in new, more expensive bottles, or
2) Finding some new way to hide or ignore risk.

But that still leaves a few innovations that are useful. To deal with the dangerous ones you can either (a) ban or otherwise significantly impede innovation or (b) rely on regulators’ judgment to sift the good from the bad. My point is that (b) is never going to work all that well. Which leads one either toward less regulation or more explicit, codified regulation that will inevitably slow financial innovation. (Or a little of both.)

Economist Dani Rodrik put it nicely a couple of months ago:

We bemoan the shortcomings of prudential regulation after each financial crash. That should teach us that policy needs to extend beyond prudential regulation to a wider set of instruments.