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  • Regulators No More Prescient Than Market

    The DC Examiner has a mostly wonderful editorial pointing out that the regulators missed the warning signs of the market crisis as much as the investment banks did. The Examiner properly concludes the question is not “more” or “less” regulation, but then wrongly implies there was no regulation “at all”.

    A very long Securities and Exchange Commission Inspector General report on the Bear Stearns failure can be boiled down to the Examiner’s first point. The SEC saw warning signs at Bear Stearns, and Bear’s internal risk managers did as well. The problem is that neither the regulator nor the internal risk managers took action because both thought the risk of a mortgage market melt-down was so remote as to be not worth acting on. In fact, Bear’s own managers acted more quickly than the regulators once the mortgage melt-down began, but still not fast enough to save the company.

    Throughout this period there was extensive regulation of Bear Stearns and other investment banks (the “Consolidated Supervised Entities” program). And, the IG report concludes, for the most part the SEC enforced, and Bear complied with the relevant regulations. The problem was that the regulations simply were not written to address a situation that had never occurred before. The regulation was not “too much” or “too little”, nor was regulation absent, it was simply, and badly, mis-focused.

    The important lesson in thinking about updating regulations is that the regulators were no more alert to new and unexpected risk that the regulated firms. And, when the risk manifested itself, the firms were quicker to act that the regulators.

    This does not mean we shouldn’t revise regulations to incorporate lessons learned from the current crisis: quite the contrary. But we should not assume that regulators have special wisdom that bankers lack, or that investment banks were blind and totally careless of risks.

    The Examiner is right, if we debate “more regulation” versus “less regulation” we will miss the critical point of how regulations should work. One important lesson of the current crisis is that no regulation can or will protect us from every risk. Assuming regulators are wiser than markets is simply to make the opposite mistake or assuming that markets can operate with absolutely no regulation at all.

    Posted in Economics [slideshow_deploy]

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