That smarts . . .

This piece from liberal arch-nemesis Matt Steinglass is fairly typical of the responses to my post on financial regulation:

The point of regulators is that they are different from investors because they approach markets as neutral arbiters, who don’t stand to profit from any proposed instrument. They counterbalance banks not because they are smarter than banks, but because they don’t stand to personally or organizationally make any money if an instrument turns out to generate money, so their assessments are not colored by the tint of hypothetical lucre. Of course banks’ desires (to roll around in piles of freshly minted bills) are partially counterposed by their fears of risk (ending up standing on the corner wearing a pickle barrel selling pencils), but that’s still not the same as being impartial and financially uninterested. Judges are not smarter than lawyers, and basketball referees are not smarter than players or coaches. They’re necessary not because they’re smarter but because they are unbiased.

It is my understanding that judges do, in fact, tend to be picked from the top of their profession, but leave that aside. This somewhat misunderstood what I was saying. The point is not really that regulators are dumber than bankers--though in fact, government salaries simply will not allow financial regulatory agencies to get top talent. The people there tend to be young, getting experience for the next job (often in the regulated industry); people who cannot get jobs in the private sector; and a handful of extremely committed idealists (or ideologues, as you prefer).

But assuming arguendo that the regulators are every bit as smart and well-trained as the analysts they regulate. This is adequate only for certain kinds of regulation: the kind where the goals of the regulators are fundamentally different from those of the regulated.

If they could get away with it, some companies would lie in their advertising or sell adulterated goods; we want regulators to catch them at it. Companies have an incentive to present an inaccurate picture of their financial well being to investors; that's what auditors are for. Depositors in an FDIC-insured bank have no incentive to check on whether the bank is sound, so we put regulators in charge of doing it for us.

But what happened in the markets was not a case of fraud. It was a case of the systemic mispricing of credit risk. More importantly, it was a case of the systemic mispricing of credit risk on the buy side: Bear Stearns didn't fail because it had originated too many dodgy securities, but because it had bought too many. The banks have just as much incentive to price risk correctly as the regulators do--probably more, actually, because the regulators are unlikely to get fired if they miss one. It's hard to make a clear case for managerial moral hazard as a result of the Bear Stearns bailout--they all lost their jobs.

The FDIC does a pretty good job at what it does--ensuring capital adequacy and providing for rapid and orderly wind-up of the affairs of insolvent banks. But commercial banking is relatively uncomplicated. Consider something like a proprietary derivative pricing model--how will a regulator deal with this? And how do you walk an institution with an active trading book through insolvency? The Fed basically dodged these questions by selling Bear to Morgan, which has the ability to maintain trading operations. You can't run a trading desk if every order has to go through the receiver.

So if we say "Give a regulatory body broad powers", we are inherently stipulating that the regulator will have a better risk pricing model than the banks do. As of now, however, no one has a good pricing model for these risks. The regulator will probably be more conservative than the banks--but what reason do we have to think that the regulator's conservatism will be closer to the ideal balance than whatever incentive the banks have to substitute beta for alpha? The socially optimal level of credit risk--even systemic credit risk--is very far from zero.

I guarantee that merely by writing this post, I will get at least one angry blogger or commenter ranting that I am a libertarian moron who doesn't understand the difference between PROFIT and POLITICS. Au contraire. Both are incentives that work well in some contexts, not in others. Political incentives are not a good way to organize, say, one's agricultural output. They are a very fine way to organize one's wars--or at least, better than the alternative.

You cannot simply assume a priori that regulatory incentives will be more socially optimal than the profit motive. Profit, in this case, a pretty strong motive for doing what we want them to do: avoiding catastrophic failures. That's why I think that a powerful regulatory body is only an unquestionable win if you have some reason to think that it will be smarter than the banks.