Thursday, July 10, 2008

Do we need more financial regulation? : The Hank and Ben Show

A lot of good points were raised in today’s joint Congressional testimony by US Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke.

I think that Paulson’s main point, and the one that we should all take away, is that banks and financial institutions should be allowed to fail. The practice of bailing out institutions in financial distress undermines market discipline, and creates the moral hazard that these firms will continue to take ever-larger risks in the future.

Ben Bernanke’s main point is that the Fed needs additional authority to deal with these situations. Dealing with and bailing out non-bank financial institutions are outside the Fed’s current mandate and regulatory authority. He wants more regulatory authority so that in the future, he can prevent from happening another situation where a non-regulated institution that is too large to fail will need Fed funding.

Bernanke is correct in saying that if the Fed had not done what it did in the Bear Stearns case, the fallout throughout the rest of the financial community would have been much larger and more adverse. Credit tightening would have been worse, which would have had worse effects for regular people and their ability to access loans and capital. Bernanke adeptly turned around a congressman’s questioning, and complaint about a constituent not being able to access loans for education into a strong point to strengthen his position. It is in keeping with the Fed’s mission to ensure liquidity and credit availability in the financial market that the bailout of Bear Stearns happened.

Despite questions from several congressmen to concretize the regulatory changes being proposed by both Paulson and Bernanke, no specific points or timelines were provided. As mentioned by Paulson, these are unusual circumstances, and more time is needed to think about the specifics of the changes that need to be made in the system.

In the end, I think Congressman Ron Paul made the best point when he said that increasing regulation has never solved the problems of fraud and mismanagement in the financial market. After Enron, a lot of changes were legislated, specifically those contained in the Sarbannes-Oxley act, but they only ended up making it worse for businesses in general to conduct their affairs. Despite that act, we still see a lot of financial mismanagement.

Paul indicated that it is the loose monetary policy that led to the environment where real interest rates are much lower than inflation that is the cause of this current problem. Because banks were provided more liquidity than what the market can absorb into real business activities, they ended up having to lend these into less and less viable outlets.

To summarize how I personally think about the situation, a little regulation may be good, but by itself, will not be the solution to avoid this problem in the future. There are indeed activities that need to be monitored by the Fed if it wants to avoid another instance in the future where it needs to step in and intervene the way that it did with Bear Stearns. But to be able to this monitoring adequately, the Fed will have to drastically increase its personnel. It needs to do so to beef up its expertise in watching over securities firms, whose activities are geometrically more complicated than what the Fed has been used to regulating - the commercial banks. More actively regulating investment banks and securities firms will only increase the federal budget, and yet, in my opinion, those who wish to circumvert the Fed will always be one step ahead of the regulator. Investment banking activities are not as codifiable as commercial banking, and hence, espouse a more "anything goes" culture.

It would be better to take from Cong. Paul’s point, and to ensure that the over-all environment where these financial institutions take part does not provide incentives for excessive risk-taking or misdirected enterprises. In the end, the market will always decide what is best, based on the over-all environment that it finds itself in. It will respond according to the incentives provided it.

If the monetary environment does not pump excess liquidity into the market, it will not foster a market culture where money is thrown at any activity that calls itself a business enterprise. After all, a financial institution’s function is to allocate capital. If there is too much capital, there is opportunity cost if an institution will just sit on that capital without recycling it back into the economy.

Fed activities which end up leading to this loose liquidity environment, therefore, should be re-thought. Too much money supply growth can lead the market right back to a Bear Stearns scenario at some point in the future, albeit at a new iteration.
Beyond rethinking monetary policy, selective regulation coupled with allowing insitutions to fail, could be the best option we can have. Hank and Ben, please show us more.

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