Regulation or Deregulation

Capitalism has never been so challenged since the Great Depression. And state interventions in markets now seem the only way out. Without the American and European governments buying stakes in banks and lending directly to corporates, the credit market would seemed to be clogged forever. And consequently much more businesses would go bankrupt and unemployment would soar and a depression would be certain. Alan Greenspan, the former Fed Chairman, has always claimed that deregulation is a main driver for the past two decades of fast growth in the U.S. How true it is we are not certain. But obviously, many of the root causes of the current crisis come from not regulating the financial system properly. The important question for the future is, how big a role should the government play in the market.

With the scale of the mess seen in past weeks, those in favor of more regulation is quickly gaining ground. It is true to certain extent that regulations can stop financial instutions from taking excessive risks, but they may also have unintended consequences which encourage risk taking. For example, the Basel Accord requires banks to put a portion of capital as reserves to cushion against bad times. This by all means seem an effective method as it restrains banks from putting all its capital at stake. However, what happened was that financial firms come up with innovations to move the risky assets off balance sheets and take advantage of it as far as possible. It is one reason why securitization of mortgages, collateralizated debt obligations and credit default swaps have become so popular in recent years.

So the correct question is not asking how much regulation we need, but how to regulate better. In terms of this, one principle stands out: transparency. The main reason why banks now are not lending to each is the opacity of banks' financial health. Counterpary risk is hard to estimate when toxic assets are held off balance sheets. Therefore, a reform of accouting rules requring disclosure of highly risky assets is necessary. But that is still not enough because these assets are often complexly strctured and hard to price fairly. As models that are accepted industry-wide can only be found in Alice's wonderland, a better and simpler solution is to restrain the exposure of banks to these opaque products.

Without doubt, the regulations can hurt banks' profitability, in short term. But it is now evident that excessive profitability in the short term often is the preclude to going bust in the near term.