The Market Needs Dynamic Regulation

There is a lot of debate about the role of regulation in the market. Free market critics say that deregulation was a core cause of the economic crisis. Leftist hawk Arianna Huffington wants to laugh laissez-faire capitalists “off the stage” and refuses to accept that anything but deregulation is to blame for our current malaise. And who can forget Sarkozy’s laissez-faire is dead comments. But on the flipside, these critics can’t really point to a single regulation that was cut in the past several decades with any meaningful relevance to the housing bubble. (Potentially Glass-Steagall could be considered problematic, but repealling that could be considered part of the solution because it allowed commercial banks to buy investment banks which were over leveraged and keep the investment banks from going under.) At the same time, arguing that “over-regulation” was the problem not exactly right either. While there were certainly some rules that caused problems–prime example is mark-to-market accounting rules–their mere existence wasn’t necessarily the trouble maker, it was more of a design failure. The regulations weren’t dynamic enough to keep up with evolving investment vehicles and practices. It has been said that rules were made to be broken, and when it comes to any regulation or law, there are always people trying to find away around the restrictions, or manipulate the system. When regulations are put in place that coerce market activity and market actors have to maneuver around them this decreases wealth production, and thus creates the arguments against regulations. But the principle of mark-to-market is to ensure the health of financial institutions and fight fraud, thus it should not be thrown out ad hoc. When President-elect Obama and Congress go to redesign the regulator system (if they get around to it) they shouldn’t try to increase or decrease regulations based on quantity, but rather look at the quality of the regulations that exists. For instance, mark-to-market could be put on a 3 year average instead of 24 hour measure for capital requirements. Of course the market value always represents future price assumptions, so that might not be the best way to approach it. The point being that the regulation should be dynamic, not static. We can’t set a rule like m-t-m and expect it to work forever. Consider rating agency regulations. Robert Rosenkranz, chairman and CEO of Delphi Financial Group, has an excellent op-ed in the Wall Street Journal this morning that says Obama should write rating agencies out of the law. Too many capital requirement regulations are tied to rating agency determinations. The inherent problem with this is that the rating agencies determine risk level based on human assessment which is as fallible as any investors guess of a future stock price. Rosenkranz writes:

Indeed, that is the entire raison d’Ã?ªtre of the $6 trillion structured-finance business, which serves little economic function other than as a rating-agency arbitrage. Subprime mortgages (and all manner of other risky loans) held directly by financial institutions are questionable assets with high associated capital charges. Each one alone would deserve a “junk” rating. Structured finance simply piles such risky assets into bundles and slices the bundles into tranches. The rating agencies deemed some 85% of the tranches by value as AAA, and nearly 99% as investment grade — thus turning dross into gold by a sort of ratings alchemy. This ratings alchemy created enormous demand for dross — in this case, dodgy mortgages. Credit was extended to countless dubiously qualified purchasers of homes, which in turn drove dramatic increases in house prices. The housing bubble has now burst, with average house prices in America down some 20% to 25% from the peak. This led to the current crisis. The problem was not the erroneous ratings per se; everyone misgauges risk and ratings agencies are no different. The problem is that these erroneous ratings were incorporated into law. Regulators should not have relied on ratings agencies to asses the risk of bond holdings. Instead, they should have relied on markets.

If federal regulatory agencies had a more dynamic approach to observing market activity, they could have proactively approached this rating agency problem and helped stave off some of the intensity in our market collapse. Dynamic regulation requires looking to the future and being tenacious about assessing market trends. It means working with market actors and designing regulations that promote a healthy financial system and avoid coercing market activity. As Rosenkranz points out, using the market to help guide regulatory activity is the best way to go. While the nation’s best minds are required to fix the broken system, they can’t solve everything, they can’t stop everything, and whatever is decided now will have to change soon as the market adapts, grows, and evolves.