Thursday, June 3, 2010


The current push by national governments and international organizations for more financial regulation and mandated insurance schemes shows that politicians and bureaucrats have forgotten the dismal history of such policies.

Many studies found that regulation not only imposes high costs of compliance on governments and firms, it also all too often results in government failure that damages the interest of consumers more than did the market failures the regulation was designed to fix. These findings drove the recent, widespread deregulation of the airline, trucking and other industries in the US and around the world.

The most telling evidence concerning the cost of government failure involved a comparison of the prices of tickets for unregulated flights between Los Angeles and San Francisco with those for the equidistant but regulated flights between Boston and Washington. The unregulated, competitively determined ticket prices were one half of those that existed under regulation.

How and why did this happen? The answer is that the regulators were “captured” by the regulated and made decisions that served the regulated industries at the expense of consumers. The capture occurred because the people charged with administering the regulations were chosen on the basis of the specialized knowledge they had acquired as former employees of the regulated industries or because they were advised on current issues by experts in the pay of the regulated industries.

The recent oil-well disaster in the Gulf of Mexico is just another example of such a capture of the regulatory regime by the regulated. It has been blamed on the inadequate enforcement and the modification of regulation of the industry, the most important of which was economic. It limited liabilities of firms that caused the environmental damage, severely reducing the market incentives to take adequate measures to prevent the damages from taking place.

The second problem associated with all regulation is that it results in unintended consequences that often cause new problems. For instance, the punitive taxation of salaries for executives above one million dollars in the United States induced firms to compete for talent by the much increased use of bonuses, which in turn resulted in more policies focused on bonus-paying short-run profits that have been blamed for the misallocation of resources and contributing to the current financial problems.

Another example of unintended consequences of regulations involves banks’ capital requirements based on the riskiness of investments. Banks avoided this regulation by establishing separate corporate entities that housed the management of such risky assets, often just using the same personnel that had carried out the activity in house.

As a result, banks met the regulatory requirements but continued to earn profits from the risky investments through the dividends paid by the companies they owned. The unintended consequence for financial stability was that the operations of these new entities escaped the direct supervision by the banks’ boards of directors and the scrutiny of their stockholders and that their failure contributed much to the depth of the recent crisis.

One of the new types of organizations created by banks and independents were the so-called hedge funds. Their engaged in some highly innovative activities, increased the flow of capital to new ventures and raised the efficiency of capital markets in general. We have long had fire, accident, life and crop insurance. Now we also have bankruptcy insurance serving investors. But these funds and other issuers of new financial derivatives were not covered by regulation and have been seen by many to have contributed to the severity of the recent financial crisis.

The failure of governments to regulate the new hedge funds and derivatives is indicative of their inability to keep up with the development of new financial institutions and practices, which surely will occur again. And that is a good thing, because otherwise financial innovation would come to a halt to the detriment of economic efficiency and growth.

It is tragic that the protection of the public from the systemic problems accompanying the failure of financial institutions will rely on new regulations when there already exists a simple and proven method for dealing with the issues.

When a financial institution cannot meet its obligations, Chapter 11 procedures should be invoked so that it can continue with its normal business activities, while under the supervision of courts, attempts are made to restore fiscal health through refinancing and changes in business practices. If these measures fail, the firm has to declare bankruptcy and arrange for an orderly, legally specified settlement of debts out of remaining assets. This process worked well for firms in the airline business and other industries. There are no fundamental reasons why it would not work for financial institutions.

The second major policy initiative that has followed the recent crisis is the proposal to establish funds to be used for the bailout of failing financial institutions. The big problem with this measure is that it will induce moral hazard behaviour. Just like people with health insurance have increased doctor visits and restaurants that have fire insurance burn more often, so will financial institutions protected from bankruptcy require increased need for financial bailouts.

Mandated government insurance against the failure of financial institutions has the further undesirable consequences of making consumers less vigilant. Knowing that a bank deposit is insured results in less scrutiny of banks by rationally acting depositors. The same outcome is certain, but much more important for the economy once the more complex obligations of financial institutions, like derivatives, are guaranteed by the planned bailout systems.

Moral hazard behaviour can be limited by the use of deductibles and co-insurance. Not all but only a fraction of bank deposits should be insured. Shareholders in banks already bear the main risk of failure but their incentives are blunted by the knowledge that their institutions are “too big to fail” and therefore will be bailed out by governments.

There is one final serious problem with regulation, which stems from the fact that they have to be enforced by fallible humans. The problem is readily seen by considering the parallel between financial regulation and rules governing sports. If the past is any guide, fans at the upcoming World Cup of Soccer in South Africa will be protesting what they consider to be faulty interpretations of the rules of the game by the enforcers of existing rules. One can only hope that the protests will be limited to screaming and will not result in the sort of riots that have taken place in the past.

In this context it is worth noting that Canadian commercial banks have weathered the recent global financial crisis much better than US banks. At a recent conference on what US regulators could learn from this experience, experts agreed that the greater financial stability in Canada was due much more to proper enforcement of existing regulations than to differences in their design and scope.

Another illustration of the crucial role played by enforcers was revealed by the news that the US Security and Exchange Commission had agents on the premises regularly and for extended periods auditing the financial affairs of Bernard Madoff when his Ponzi scheme collapsed and caused untold hardships to many investors.

History is clear. Leaving in place or in many cases restoring the penalties that are dished out by free markets to those who go bankrupt and cause fluctuations will minimize the costs they impose on society much better than more regulations and controls.

Politicians eager to be seen as doing something to prevent future financial crises would be well advised to study the sordid record of regulation. They should learn that some financial and economic fluctuations are inevitable under capitalism, representing a cost that has been repaid many times by the dynamism of free markets and the rise in income and welfare they have produced.