Monday, July 23, 2007

Another View on the Role of the Regulator

Another view on the role of the regulator that ties in well with the post below. Excerpts from the WSJ article are below the entire article is worth the time. I am still in favor of the regulators using their power to cut-off risky lending practices at the source, thereby protecting the consumer and allowing the firms that take inordinate amounts of risk in the credit markets to fail. Basically, I am not interested in bailing out firms that take on inordinate amounts of risk with the taxpayers money. You want the big return you take on the big risk.

Congress is about to propose new regulations for hedge funds. German Chancellor Angela Merkel has the same bad idea, meanwhile the British Financial Service Authority, currently worrying about excessive debt issued to finance acquisitions by private-equity firms, may be next in line. But whatever the perceived problem, more regulation is not the answer. It is far better to change some incentives for excessive risk-taking. The old saying is true: Capitalism without failure is like religion without sin. (my emphasis) The answer to excessive risk-taking is "let 'em fail."

History has taught us that not only do regulations not rein in excessive risk-taking, but they often do more harm than good. More than 50 years passed before Congress and the regulators repealed mistaken legislation such as the Glass-Steagall Act that prohibited banks from doing business across state lines, or Regulation Q that restricted interest payments on bank deposits. The damage done by the most recent big blunder -- Sarbanes-Oxley -- has proved no less difficult to remove.

Regulation will not solve the problem of risk-taking that has returned many times, under many different regulatory regimes. If there is a current problem of excessive risk-taking, it arises from financing long-term investments with short-term borrowing. This is an often-repeated problem in financial history that ends badly for many of the risk-takers, especially if the economy experiences a recession.

The good news is that risk-taking, even when it fails, has not stopped prosperity from continuing. The world economy enjoys sustained growth. Household incomes are rising. Corporate profits remain strong. As long as this continues, debt-servicing problems will remain limited. One remaining problem is herd-like behavior among managers and portfolio investors. . . .

In conclusion the author states:

. . . . A strategy for reducing risk is overdue. Instead of burdensome regulation, the Federal Reserve and other regulators should develop a strategy, announce it and follow it whenever the next round of failures appears. Bailouts encourage excessive risk-taking; failures encourage prudent risk taking.

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