Two, four, six, eight . . . how we gonna regulate?

A number of readers have emailed me to ask what I thought of this:

Austan Goolsbee, an economics professor at the University of Chicago and one of Sen. Obama's closest advisers on economic issues, said the senator believed strongly in enhanced regulation of any financial institution that has access to the Fed's discount window.

"If you can borrow money from the U.S. taxpayer at a moment of crisis, that is a very sacred insurance policy underwritten by the U.S. taxpayer," said Mr. Goolsbee in an interview last week with Dow Jones Newswires. "We have the right to oversee anyone who is accessing that insurance policy."...

Mr. Goolsbee said that an Obama presidency would ensure that investment banks are regulated as closely as commercial banks.

Greg Mankiw asks: "Can an investment bank avoid such regulation if it promises never to use the discount window? Or is this insurance-regulation combo a mandate?"

I'm not sure that's the right question. As Matt pointed out yesterday

My first read on this was that a "promise" would be no good. A bank can't "promise" not to fail. Nor can a bank promise not to be bailed out if it does fail. A bailout, when justified, isn't a favor you do for the bank. It's something you do because it's necessary to avoid larger negative consequences throughout the economy. So a promise to avoid the discount window would be valueless. But if the public is going to need to guarantee that financial institutions that grow "too big to fail" don't fail, then the public is going to need to regulate those institutions.

Bear Stearns wasn't bailed out for the good of Bear Stearns; it was bailed out because it was the counterparty to vast numbers of trades, and the Fed was worried that markets would lock up. No bank can credibly commit not require government assistance, so in some sense, they're gambling with our money. Once you take the King's Shilling, you also take the King's orders.

The question I have is this: what regulations? Over the past few months, I have been to a dozen or more events sponsored by various think tanks that together represent most of the American ideological spectrum. Most of them think that investment banks need "more regulation"; it's a pretty strong consensus. The problem is, there are precious few ideas as to what that regulation might entail.

Here is, as far as I can tell, a comprehensive list of all the regulations that most economists could probably agree to:

1) Increased capital requirements for investment banks
2) Cracking down on fraud in the mortgage brokerage market
3) Less off-balance sheet activity
4) Requiring originators to keep a piece of the loans they package

The problem is, it's not really very likely that these four would have prevented the current crisis. If you borrow short and lend long--and all banking is some variant on this--you will at least occasionally be caught out. There's no real evidence that the problem in the housing market was supply-side, rather than demand-side, fraud. Bear Stearns wasn't taken down by its SIVs. And it's not really clear that the originators would have behaved much differently had they been keeping a piece of the loans they packaged.

The housing bubble created a powerful illusion: that low income lenders with bad credit were actually quite profitable to lend to. That's because the rising housing prices allowed borrowers in trouble to refinance rather than default. There's no reason to think that the originators were any less deluded about the credit risks than the investors. The no-doc, option and negative amortization ARMS were not a secret; everyone knew what was going on. People bought mortgage bonds anyway in what now looks like a stunning piece of idiocy.

When I try to get people to specify, beyond those four rather anodyne suggestions, we should do, there's a lot of hemming and hawing. Even the left-wing think tankers sort of look at their shoes and whisper "We need a better regulator". At which point even the left-wing journalists in the audience start asking "Where are we going to find regulators who understand this better than the guys at Goldman Sachs--and are willing to work for, say, a GS-13 salary?" The only people who confidently state that they have a surefire master plan to fix the problem are, not to put too fine a point on it, morons with very limited understanding of financial markets. These people generally start by talking about how the Bear Stearns crisis can really be traced back to the repeal of Glass-Steagall, then almost immediately reveal that they know nothing of Glass-Steagall other than its name.

I have tried all sorts of ways to ask these questions. Nor am I engaged in "libertarian gotcha"; though the game is hours of fun, I am not actually against better or even more regulation of investment banks*. I just want to know what sort of regulation we are going to have; I am against doing something for the sake of doing something.

Which financial instruments should be illegal, I ask, but few are willing to name one. How should we arrange the orderly winding-down of an investment bank with complicated business lines and massive counterparty exposure? Rueful shrugs. What business lines should investment banks be forced to divest? Ummm . . . . Should we limit the percentage of a market that one bank can control, at the risk of lowering liquidity in ordinary times? Welllllllllll . . . Should banks have broader distribution of their capital across business lines, or fewer business lines, and is either even possible to arrange without financial disaster . . . good question. Do we give the regulator broad powers, to make them more flexible, or narrow powers, to make them more accountable? Let me think about that . . .

But the fundamental question that no one ever answers is simply "How will the regulatory agency be any smarter than the banks?" The political process and existing regulatory infrastructure did about as well at anticipating and preventing the current problems as the banking system did. As I say above, this question usually gets asked by liberal journalists. And its usually answered by an honest and intelligent liberal policy wonk forthrightly saying, in essence, "I have no idea."

Now, it's certainly very possible that Austan Goolsbee has answers to at least some of these questions; he's forgotten more about finance than I'll ever know. But I'd really like to hear what they are.

* Though I am slightly taken aback by the fact that it is the already fairly heavily-regulated investment banks, rather than basically unregulated hedge funds, that have caused the problems.