Once we do enough fire-fighting to move the financial crisis from existential-threat status to just another hole we have to climb out of, the time will have arrived to redesign the developed world’s financial regulation framework. I’m not a pro, but I’ve been in business for some decades and I’m an investor and know quite a bit of accounting, and I have opinions.

Oh, and if any right-wing fundamentalists or Randroids want to explain how if government just gets out of the way the market will protect us, please first read this and then go away. Thank you.

Introduce Reasonable Judgment · Too much of the regulatory framework has historically been an effort to write rules that are so tight and detailed that the financial systems’ sharpies can’t find away around, through, or under them. It doesn’t seem to work very well. If I were redesigning the sucker, I’d dramatically slash the number and size of the rules and rely in almost every case on “reasonable judgment”.

In this, you get rules of the form “You can’t sell anyone an investment they can’t reasonably be expected to understand.” Or “You can’t develop any financial instrument whose purpose can reasonably be judged to move a liability off the balance sheet.” Or “Banks can’t let their capital ratios drop below a level that can reasonably be judged to be safe.”

Yeah, this would give the court system a perhaps-dangerous amount of power and leeway. I’m fine with that; it’s hard to believe that it could be any more dangerous than what we’ve seen in recent decades.

Ratings Agencies · There are a lot of culprits who share the blame for the current debacle, but there’s only one group which clearly could have stopped the whole thing in its tracks if operating as intended: The ratings agencies. The idea was that anything rated AAA should be safe enough to drop into a pension fund. It’s not that none of them will ever default, but that the proportion of failures will be small enough that if you diversify a bit, you’re confident of capital preservation.

Of course, what happened was that the rating agencies became dependent on credit issuers for their bread and butter, and the onset of corruption was 100% inevitable at that point. There was a time in history when debt buyers paid the ratings agencies; several of the postmortem analyses I’ve read explained the change-over with something along the lines of “The volume and complexity of credit instruments made this nonviable as a business model.”

BZZZZZZZZZZZZZZT! Wrong. What we ended up with was really nonviable. If you can’t afford to pay someone qualified to get an independent opinion, then you can’t afford to loan the money. Maybe a coherent case can be made that these puppies ought to be in the public sector. If you’re doing it to protect the interests of investors it can hardly be socialism, can it?

I’m not smart enough to prescribe the ideal solution. But anyone with half a brain can see that ratings agencies in the pay of debt issuers can’t possibly be part of it.

Share the Pain · This is an idea I got last month from Nick Carr’s piece No Worries. Specifically, he proposes modifying deposit insurance, essentially by adding a deductible like I have on my auto insurance. The idea is that you don’t want citizens’ deposits wiped out in a bank failure, but maybe it’s not a bad thing to impose a little pain on them in that circumstance, to make us all a little more paranoid and suspicious about bankers.

There’s an analogy here to the open-source dogma: “Given sufficiently many eyes, all bugs are shallow.” The idea is that if everybody involved in the system shares some part of the risk of failures, the general level of vigilance is thereby increased and with any luck some of the failures are averted.

The Balance Sheet is Sacred · I am quite skeptical of some of the core tenets of the accounting profession’s belief system; for example, the superstition that capital spending and operational spending dollars are magically different from each other. Having said that, the notion of the balance sheet seems to be sort of at the center of everything: Here’s what we have, here’s what people owe us, and here’s what we owe.

But time and again, when crisis strikes all sorts of liabilities crop up that were somehow magically absent from the balance sheet. In fact, the whole raison d’etre of postmodern financial instruments like the SIV was to move things off-balance-sheet. I, like everyone else even remotely connected to the finance industry, has seen presentations from time to time advertising the advantages of this kind of structured product.

At this point, the phrase “off-balance-sheet” makes my blood boil. If I were writing the next revision of the financial regulations, it would include something along the following lines: “Should a company enter into any contractual relationship which at some point in time imposes a liability on the company, and should it be established that this possibility was not accurately described in the company’s balance sheet, this is deemed evidence of criminal intent to defraud on the part of the company’s Directors and Officers.”

That might get their attention.


Comment feed for ongoing:Comments feed

From: Brad Fults (Nov 10 2008, at 17:44)

With respect, your disparaging remarks and subsequent summary dismissal of those who may not favor a scheme of regulation is unbecoming at the least. I would recommend a simple statement of intent and provision of context, if only in the endless quest for perfection in discourse. For instance, "This discussion is focused on the merits of a few regulatory techniques and a regulatory scheme is assumed. The merits of a completely deregulated system will be left for another day."

As far as the concept "reasonable" being penned into laws, you have to remember that the judges making the decisions and the politicians pushing them should be assumed to be biased, thus "reasonable" loses almost all meaning in any given decision. To move to a technical analogy, the current system seems much like a blacklist, your suggestion sounds like a whitelist with wildcards and I think the optimum probably lies closer to a strict whitelist. In this way it would be attempting to copy the style of the US Constitution and other early instructive documents.

I think you're entirely correct to place the majority of the blame—or at least the power to have prevented the disaster—on the rating agencies. It is indeed a huge problem that they are paid by the debt issuers and that is probably the most fundamental issue in this morass. It would just be vastly better if the incentives were realigned such that rating agencies were naturally in services to the borrowers and investors, rather than trying to force something that is not currently coming naturally.


From: Michael Buckbee (Nov 10 2008, at 18:04)

On the reasonableness front, I'd also add "too big to fail is too big".


From: Doug Ransom (Nov 10 2008, at 18:18)

Regulation was the initial cause of this crisis - regulation that put social agendas ahead of the stability of the financial system. Financial engineering played a role, but the root cause was the housing bubble as the result of lending to people who should not have qualified. I love this quotation from Harry Markowitz ' “If the choice is requiring mortgages for people who don’t qualify or keeping the banking system sound, we should learn to opt for sound banking every time,” he says. Also, since “financial engineers seem to get their necks chopped off periodically”, they shouldn’t get bailed out when it happens. '


An insurable interest approach to credit-default-swaps might be a sensible idea to protect the system - you can't buy a CDS unless you own a bond, and you can't sell one unless you either have one already.

"You can’t develop any financial instrument whose purpose can reasonably be judged to move a liability off the balance sheet" -- that is a little frightening. You might find the system more fragile, not less, by making up regulations like this.


From: Christopher Mahan (Nov 10 2008, at 18:36)

I would suggest that since publicly traded company management cannot be trusted to accurately portray financials to the owners, this puts in doubt the viability of the "publicly traded" concept.


From: Seth Gordon (Nov 10 2008, at 18:39)

I absolutely disagree with the "share the pain" proposal.

If a bank's balance sheet is sketchy enough that an ordinary citizen has reason to fear for the safety of his or her deposits, then it's sketchy enough for the regulators to shut it down. If regulators are unwilling to do that and ordinary depositors have some of their money at risk, then the financial system will become less, not more, stable--because depositors will be more likely to make runs on banks that are merely rumored to be unstable.

(And once a financial panic is underway, no bank is safe. I have my deposits at a subsidiary of the Royal Bank of Scotland, which had no direct exposure to the subprime mortgage silliness, but their bonds were downgraded anyway and they applied to the Bank of England for some bailout money.)

If I thought I had some special insight into which banks were less likely than others to fail, I would use that insight as an investor, not a depositor.

The analogy with open source fails because there's no such thing as an open-source bank. (And since the soundness of a bank depends in part on the recursive closure of the soundness of all its debtors, then in order to have an open-source bank we'd have to have an open-source financial system.)


From: JIm Ancona (Nov 10 2008, at 18:59)

Ok Tim, I read this item as well as your linked "Business" piece. Now I hope you'll read this (http://myslu.stlawu.edu/~shorwitz/open_letter.htm) and consider how much government regulation contributed to the current crisis and how likely it is that we will get better regulations, as opposed to regulations that better serve the large corporations and financial institutions that created the mess.



From: James Robertson (Nov 10 2008, at 19:38)

I like your idea:


In this, you get rules of the form “You can’t sell anyone an investment they can’t reasonably be expected to understand.” Or “You can’t develop any financial instrument whose purpose can reasonably be judged to move a liability off the balance sheet.” Or “Banks can’t let their capital ratios drop below a level that can reasonably be judged to be safe.”


But it's the opposite direction from where things are moving. Consider something far more basic, like rules at high schools. When my sister and I went (30 years back now), we could bring cough drops, or aspirin/tylenol with us. Now?

My daughter would get busted for a drug violation if she brought an advil in. Heck, Ricolas are banned. The system is moving towards more and more specific rules, in an effort to remove judgment calls completely. I thinnk it's the wrong way to go, but it seems to be the way everyone - pretty much without regard to ideology - wants to go.


From: John Cowan (Nov 10 2008, at 20:13)

In the linked fragment on business, you call Adam Smith a cheerleading ideologue for capitalism, and perhaps he was. But he was surely no cheerleader for capitalists, who he profoundly distrusted, and with good reason:

"People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices."


From: Stephen Waits (Nov 10 2008, at 20:17)

Our market hasn't been free in a LONG time. Far from it.

Regulation caused today's nightmare. Less, or different, regulation may or may not fix it.


From: Bob Aman (Nov 10 2008, at 20:33)

Re: Share The Pain

My old bank was one of the first to fold. I had the foresight to see it coming, and I moved all of my funds out about a week before the FDIC rolled in. In principle, I think what's being suggested here is a good idea. I am, however, very confident that in practice it would be horrible, at least during a period of economic distress. It would, for all intents and purposes, be destroying wealth rather than preventing wealth from being lost, and the general public would be in an uproar as a result. It's the sort of plan that would only work if implemented during a period in which the economy is strong and banks <em>aren't</em> failing. Also, that's the only time anyone would ever be able to sell an idea like that anyhow.


From: Rob Sayre (Nov 10 2008, at 21:01)

I don't think the modern-day ideologues you deride in your linked fragment have much in common with Adam Smith. For instance:

"When the regulation, therefore, is in support of the workman, it is always just and equitable; but it is sometimes otherwise when in favour of the masters."

Here's Adam Smith, "redistributionist"*:

It is not very unreasonable that the rich should contribute to the public expence, not only in proportion to their revenue, but something more than in that proportion."

* Republican Talking Point (tm)


From: Fabian Ritzmann (Nov 10 2008, at 23:12)

"Reasonable judgement" has the nasty habit of turning into "arbitrary judgement" particularly in the hands of individual unreasonable government or justice officials. You can not build an economy or a judicial system on that.


From: John (Nov 11 2008, at 05:19)

Bravo to Jim Ancona for posting this link (http://myslu.stlawu.edu/~shorwitz/open_letter.htm) to help rebut the "what we need is more regulation" argument. Oh, if only the media and those in power (or soon to be - Obama) would stand up and explain the root cause instead of spewing the half-truths and unsupported assertions that make for good sound bites and fuel popular perceptions. If only...


From: denis bider (Nov 11 2008, at 05:43)

Some of your proposals make sense to me, some seem not entirely thought out.

The "share the pain" proposal, in particular, defeats the purpose of having deposit insurance in the first place. The purpose is to promote bank stability by eliminating the incentive for rumor-based bank runs.

Your "share the pain" proposal does not cause better judgement on behalf of customers - my economically ignorant grandma, or my mom, have no way, other than listening to rumors, of knowing which bank is safe.

Further, your proposal leads to a bank run if rumors start to spread about a bank's liquidity or solvency. Not a good idea overall.


From: denis bider (Nov 11 2008, at 05:56)

A big part of the problem is the agency conflict of interest, and the ineffectiveness of shareholder democracy.

This is not such a big deal when a company in the real economy goes astray. In that case, shareholders suffer, but externalities are limited.

But the problem is greater when a finance business goes astray. Especially when all of them do.

Perhaps it would not be a bad idea to require that finance businesses must have a single, controlling majority shareholder.

This would limit their size, which helps in the sense that "too big to fail is too big", and it would provide for better corporate oversight, as a single, controlling majority shareholder is more likely to steer the company on the right path than a haphazard democracy of smaller shareholders which management leads by the nose.

BTW, your anti-spam severely sucks - I was able to submit my first response, but I had to try all sorts of things to get this second one through. I kept getting the random fake messages until I tried from a different IP address.


From: len (Nov 11 2008, at 06:37)

"The idea is that if everybody involved in the system shares some part of the risk of failures, the general level of vigilance is thereby increased and with any luck some of the failures are averted."

While the financial system is certainly at fault as are the regulations such as the CRA that opened the Pandora's Box of the sub-primes, what say you about the companies being managed into mediocrity and bankruptcy by the hedge fund investors who squeeze all the slack out and force the managers to gut the rules for sensible bidding of projects?

IMHO, employee ownership (not stock participation) is the single best way to ensure a company is run well. It isn't a cure all, but it does put the investor and the owner into the same boat.

Our economies failed because we no longer own them and that allowed the financial markets to take them hostage then ransom them for a bailout without a proof of life.


From: len (Nov 11 2008, at 13:05)

I don't think open source notions such as a thousand eyes work all that well. A thousand eyes reading the Torah just mess up the margins. A Talmudic solution isn't the best.

What if to write a regulation you had to first describe institution that would fail if the regulation didn't exist?

In other words, what if regulations were submitted to the same discipline as test driven design?


From: John Turner (Nov 11 2008, at 15:02)

What would happen if the regulators said this: "Credit enhancements are a pleasant idea in good times and might well improve capital allocation overall. However, they set up completely perverse incentives and bring about synthetic markets that generate fees but don't adequately pass risk around in the bad times. So they don't count when calculating regulatory capital anymore and credit ratings agencies can't pay any attention to them, or anything that smells like them, in deciding what badge a security should wear. Have a nice day."? Just asking.


From: Martin Probst (Nov 12 2008, at 00:58)

I feel your pain about much to detailed laws and people finding loopholes in them all the time. But I think the "reasonable judgement" thing is really a bit naive. People will not use reasonable judgement due to the power of greed, and when they are in front of a judge, it might be much too late.

Also, this regulation system has to work on an international scale. Good luck with trying to get a Swede, a French, a Chinese and an American judge to agree on what is reasonable judgement. I think we really need to spell this out, everything else is going to be chaos.

"The Balance Sheet is Sacred": yes, very much indeed. And this whole crisis is in my opinion in no small part due to the fact that banks found a loop hole in accounting. At least in Europe, for every credit a bank gives, it has to have a certain amount of equity to back it up. In this case, the banks managed to sell the credits in packages to other banks, and suddenly no one had to have the equity backup anymore. So the banks could make a lot more money out of their limited equity, as they could give a lot more (risky) credits. This worked as long as most of the credits didn't fail, but when credits blew up, the whole system started shaking. Sounds quite obvious in retrospect, doesn't it?


From: Bill Burke (Nov 12 2008, at 15:48)

I don't think a "deductible" would work. The reason for FDIC insurance is to prevent a run on a bank. Even a 10% loss could create a run, IMO, but what do I know? I'm just a software engineer.

Also check out this article:



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