Legal Commentary

Re-Regulate Financial Markets?--Posner's Comment

By Richard Posner

I no longer believe that deregulation has been a complete, an unqualified, success. As I indicated in my posting of last week, deregulation of the airline industry appears to be a factor in the serious deterioration of service, which I believe has imposed substantial costs on travelers, particularly but not only business travelers; and the partial deregulation of electricity supply may have been a factor in the western energy crisis of 2000 to 2001 and the ensuing Enron debacle. The deregulation of trucking, natural gas, and pipelines has, in contrast, probably been an unqualified success, and likewise the deregulation of the long-distance telecommunications and telecommunications terminal equipment markets, achieved by a combination of deregulatory moves by the Federal Communications Commission beginning in 1968 and the government antitrust suit that culminated in the breakup of AT&T in 1983.

Although one must be tentative in evaluating current events, I suspect that the deregulation (though again partial) of banking has been a factor in the current credit crisis. The reason is related to Becker's very sensible suggestion that, given the moral hazard created by government bailouts of failing financial institutions, a tighter ceiling should be placed on the risks that banks are permitted to take. Because of federal deposit insurance, banks are able to borrow at low rates and depositors (the lenders) have no incentive to monitor what the banks do with their money. This encourages risk taking that is excessive from an overall social standpoint and was the major factor in the savings and loan collapse of the 1980s. Deregulation, by removing a variety of restrictions on permitted banking activities, has allowed commercial banks to engage in riskier activities than they previously had been allowed to engage in, such as investing in derivatives and in subprime mortgages, and thus deregulation helped to bring on the current credit crunch. At the same time, investment banks such as Bear Sterns have been allowed to engage in what is functionally commercial banking; their lenders do not have deposit insurance--but their lenders are banks that for the reason stated above are happy to make risky loans.

The Federal Deposit Insurance Reform Act of 2005 required the FDIC to base deposit insurance premiums on an assessment of the riskiness of each banking institution, and last year the Commission issued regulations implementing the statutory directive. But, as far as I can judge, the risk-assessed premiums vary within a very narrow band and are not based on an in-depth assessment of the individual bank’s riskiness.

Now it is tempting to think that deregulation has nothing to do with this, that the problem is that the banks mistakenly believed that their lending was not risky. I am skeptical. I do not think that bubbles are primarily due to avoidable error. I think they are due to inherent uncertainty about when the bubble will burst. You don't want to sell (or lend, in the case of banks) when the bubble is still growing, because then you may be leaving a lot of money on the table. There were warnings about an impending collapse of housing prices years ago, but anyone who heeded them lost a great deal of money before his ship came in. (Remember how Warren Buffett was criticized in the late 1990s for missing out on the high-tech stock boom.) I suspect that the commercial and investment banks and hedge funds were engaged in rational risk taking, but that (except in the case of the smaller hedge funds--the largest, judging from the bailout of Long-Term Capital Management in 1998, are also considered by federal regulators too large to be permitted to go broke) they took excessive risks because of the moral hazard created by deposit insurance and bailout prospects.

Perhaps what the savings and loan and now the broader financial-industry crises reveal is the danger of partial deregulation. Full deregulation would entail eliminating both government deposit insurance (especially insurance that is not experience-rated or otherwise proportioned to risk) and bailouts. Partial deregulation can create the worst of all possible worlds, as the western energy crisis may also illustrate, by encouraging firms to take risks secure in the knowledge that the downside risk is truncated.

There has I think been a tendency of recent Administrations, both Republican and Democratic but especially the former, not to take regulation very seriously. This tendency expresses itself in deep cuts in staff and in the appointment of regulatory administrators who are either political hacks or are ideologically opposed to regulation. (I have long thought it troublesome that Alan Greenspan was a follower of Ayn Rand.) This would be fine if zero regulation were the social desideratum, but it is not. The correct approach is to carve down regulation to the optimal level but then finance and staff and enforce the remaining regulatory duties competently and in good faith. Judging by the number of scandals in recent years involving the regulation of health, safety, and the environment, this is not being done. And to these examples should probably be added the weak regulation of questionable mortgage practices and of rating agencies' conflicts of interest and, more basically, a failure to appreciate the gravity of the moral hazard problem in the financial industry.

Full post as published by Becker-Posner Blog on April 28, 2008 (boomark / email).