Continuing the discussion from the last post about what politicians really mean when they say (and fail to say) things, I have come to the news item that initially sparked my thought process. It involves an old friend of ours. Welcome back Timmay!
With all the sound and fury lately regarding financial regulation and “systemic risk,” it is interesting to see Tim “Timmmmay!” Geithner urging “global minimum standards” for derivatives regulation. In the same breath he urges against a “race to the bottom.” By now, we should all know where I am going with this.
By positing a “race to the bottom,” Geithner implicitly admits that investors, traders, and various other market actors would prefer less regulation. If the derivatives trading market found the regulations proposed by the SEC useful, they would gladly submit. Given the choice, they simply would not.
I am sure that I would be accused of unwarranted simplicity here, but I disagree. I concede that it is entirely true that poor risk management on the part of purely private-sector actors is a recipe for crisis, and I know for a fact that in the absence of regulation, there would be many a company bankrupted in the blink of an eye. (Note, however, that regulation did not prevent these bankruptcies either; see AIG, Fannie, Freddie, Lehman, Wachovia, Washington Mutual, etc.)
So what’s wrong with Geithner’s proposal? Let’s read between the lines.
Geithner’s tacit admission that people would prefer less regulation in spite of overwhelming risks indicates that derivatives market actors do not take seriously the idea that companies will be allowed to fail or investors allowed to lose much money. In other words, market actors do not view the dangers of poor risk management – whether in the presence or absence of regulation – as a credible threat.
If they did, massive and blatant risks would have to be accounted for, and quite frankly, that would affect a huge financial company’s bottom line, and not in a good way. Why would such a company want to give up the ability to take massive risks and possibly reap massive profits if the only downside to massive losses is having the government cut you a check?
Of course the big banks have no desire to regulate themselves, but it is a problem that stems entirely from the “solution” to the last financial crisis, i.e. bailouts, and it is precisely the problem with Geithner’s proposal now. The only real solution is erasing the errors of the last faux-”solution.” What is needed is not more regulation, but healthy incentives, beginning with complete, total, and unambiguous disavowal of “Too Big to Fail.”
Remove regulation concurrently with removing the possibility of bailouts, and before the regulators could even catch their breath, financial institutions would be self-regulating their own risks. They would respond to the disciplined incentives presented them, just as they responded to the perverted incentives presented to them last time.
By claiming that only one option is available – broad-reaching, top-down, command-and-control, global regulation – Geithner tacitly backs up the current assumption that the bailout incentive has not changed. The way the market sees it, Geither is “threatening” to keep bailing companies out unless he is given godlike powers over the economy. After all, he has never once seemed to consider that market actors could possibly be responsible for their own profits and losses. Is it any wonder the big financial companies are so much happier with the status quo?
Heads, Geithner wins. Tails, you lose. It looks to me like “Too Big to Fail” is here to stay for a while.