Regulation and the crisis

One of the basic rules of banking that I teach in econ 331 is "Never take a risk you don't understand." The current crisis seems to have its roots in a new fashion in the banking industry to ignore this rule. Such behavior is remarkably foolish. But perhaps behavioral economics can explain it as a reaction to the invention of so many new types of financial instruments with extremely obscure risk characteristics. Rather than forego buying these things and risk looking stupid or slow, bankers bought them, hoping (or trusting) that their inventors were not selling them something dangerous. Of course, the result is that the bankers who bought these things now look stupid and slow. Better to say "Sorry, I don't buy things I don't understand" than to ruin your company.

Regulation could have forbade these instruments, or penalized banks that held them, but that would run a serious risk of stifling innovation, which we don't want to do. Bankers should be smart enough to reject innovations that are not transparent enough to be really useful. The real regulatory failure that is clear now (in retrospect) is that capital requirements for investment banks and hedge funds (and insurance companies that acted like hedge funds) were too low. This is the area that needs attention as we review regulation in the light of the crisis. The commercial banks and thrifts, with their higher capital requirements, are mostly OK.

While we're on the subject, I was always a fan of the original rescue plan for the Treasury to buy distressed mortgage-backed securities from the banks in a reverse auction. The government would not have had to buy all of them in order to establish a price, and private demand would have followed. Once a price was set, the size of the banks' losses is determined, and on that basis they could have gone to the private market to raise capital. But the approach that was followed (direct injections of equity capital from the Treasury) did not resolve the uncertainty about the magnitude of the banks' losses, and so did not open the private market to them. Who wants to inject capital into a bank and then see it eaten up by toxic securities that were already on the books?