Monday, September 15, 2008

Principals, agents and bank regulators 

Krugman boils it down to the essentials:
So the word seems to be that Lehman will be liquidated � hey, no more taxpayer takeover of risk, no more moral hazard; but to cushion the markets against the shock, the Fed will start accepting lower-quality assets, such as equities, as collateral for its credit lines � hence, more taxpayer takeover of risk, and more moral hazard. Oh, kay.
Here are the details of what the Fed has done: More liquidity offered, in return for sketchier paper. Lehman apparently was heavily involved as the guarantor of third-party repos, so the Fed is offering to stand in the breach on Lehman's behalf.

Tyler Cowen makes a good point in yesterday's NYT regarding bank regulation. Rick Mishkin's money and banking textbook is now in its 8th edition. Its banking industry structure chapter has changed very little over the editions (you might want to refresh yourselves on the Gramm-Leach-Bliley Act of 1999, for example, for one of the big changes) but largely the same components of the text -- multiple regulatory agencies; financial innovation; branching laws; erosion of Glass-Steagall -- are not much different from earlier editions.

One interesting change over the years has been the addition of a chapter titled "The Economic Analysis of Banking Regulation." Using the Charles Keating example, he writes:
...the structure of our political system has created a serious principal-agent problem; politicians have strong incentives to act in their own interests rather than the interests of taxpayers. Because of the high cost of running campaigns, American politicians must raise substantial contributions. This situation may provide lobbyists and other campaign contributors with the opportunity to influence politicians to act against the public interest (pp. 296-298)
I think this explains Tyler's observation:

For the regulatory category of finance and banking, inflation-adjusted expenditures have risen 43.5 percent from 1990 to 2008. It is not unusual for the Federal Register to publish 70,000 or more pages of new regulations each year.

In other words, financial regulation has produced a lot of laws and a lot of spending but poor priorities and little success in using the most important laws to head off a disaster. The pattern is reminiscent of how legislators often seem more interested in building new highways � which are highly visible projects � than in maintaining old ones.

You can argue it's an information problem -- how is the bank regulator evaluating Citi going to figure out the pitfalls in Travelers' operations, for example? -- but even if you overcome that there is still an incentive issue.

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