Did the financial markets really run wild?

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The lead paragraph of the top front-page story in the Washington Post this morning.

Treasury Secretary Timothy F. Geithner is proposing a sweeping expansion of federal authority over the financial system, breaking from an era in which the government stood back from financial markets and allowed participants to decide how much risk to take in the pursuit of profit.

I am surprised to see this narrative presented as fact.  As far as I know, banks have not been allowed to decide how much risk to take. On the contrary, they have been subject to risk-based capital requirements for nearly twenty years.  In fact, I would argue that these risk-based capital requirements, which permit banks to hold less capital for securities rated AAA, helped to encourage the boom in mortgage securitization. 


I think that a more accurate narrative would be to say that the Geithner plan and similar proposals are intended to get away from an era in which government assumed that banks held enough capital because they complied with requirements based on the Basel accords, and a crisis emerged in ways that hardly anyone anticipated.  The new plan is to set up a "systemic risk regulator," which will be in charge of anticipating what most human beings are unable to predict.

If the new regulatory structure had been in place in recent years, we would have had numerous false positives ("the trade balance is going to cause the system to blow up!"  "the hedge funds are going to blow up!"), and probably not avoided the actual problem ("there are some issues with fringe lenders in the subprime mortgage market, but the banks and Freddie Mac and Fannie Mae are prudent and well regulated").  Even if the new system is one that would have prevented the last crisis, who says that it will prevent the next one?

My view is that instead of aiming for a financial system that is hard to break, we ought to aim for one that is easy to fix.  A system with a lot of overlapping financial functions and a messy regulatory structure could turn out to be more robust than a neat, clean structure.  The UK has a more uniform regulatory structure, and last I looked their banking system was doing worse than ours.

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Arnold Kling

Arnold Kling earned his Ph.D in economics at MIT. He was an economist on the staff of the Federal Reserve Board. From 1986-1994 he worked at Freddie Mac. He started Homefair.com in 1994 and sold it in 1999. His fourth book, From Poverty to Prosperity, co-authored with Nick Schulz, is due out in April of 2009. He blogs regularly at Econlog.
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