The Regulatory State: May We Have A Little Humility, Please?
The Great Equity Correction of 2015 that is now being enjoyed by all of us is a correction, and not the beginning, of the Great Bear Market of 2015 (from my lips to God’s ears). It reminds me of just how little we know about how all complex systems, like the global financial market (and don’t get me started on climate), function. Nonetheless, our Regulatory State behaves as if this was not true and as if wise governmental types can simply declaim new rules and regulations to get their very specifically-designed outcomes.
Doesn’t work, never did, never will. But we seem to keep doing this. Isn’t this the very definition of insanity? Lots of fun learning opportunities as we watch the world economy shudder and the regulators madly regulate. But will we learn anything?
Just a few examples from desperate places and polities:
- For so many years, the masters of the Chinese economy were seen as wizards who delivered fantastic economic growth year in and year out. A track record that begot, during the past few years, serious questions about the relative value of the managed versus open economy. Now China’s stock market and financial markets are in chaos; its underlying real economy (to the extent we can believe any of its numbers) appears to be rapidly slowing and those same Chinese masters are looking increasingly like the Wizard of Oz, madly pushing buttons and pulling levers behind the curtain, hoping something good will actually happen. Perhaps signaling capitulation this week, the Chinese government has reverted to form and announced that it will now seek to arrest “market manipulators.” The August 31st edition of The Wall Street Journal carried a story about one such poor bastard who immediately upon arrest confessed to writing an article that had “great negative impact on the market.” Can’t you just see Captain Renault arresting the customary suspects? Sell a share, go to jail.
- And in the US, where has all the liquidity gone? To Dodd-Frank, to Volcker and to the other miscellaneous intrusive regulatory initiatives — all brought to us by our all-seeing and prescient Congress and White House in the lee of the 2008 meltdown. Well, five years on, we are all waking up to the realization that liquidity might just be a bit negatively impacted by all this rulemaking. Loss of liquidity is really bad. Just the other day, it was reported in the Financial Times that the Bank of England has a new analysis which it shared with us through its staff blog that when dealers can’t hold paper, the shock absorber in the system is gone. Similarly, the nine largest trading banks now need to substantiate every position they hold with the filing of a RENTD (Reasonably Expected Near Term Demands of Customers) to ensure that they don’t engage in that nasty proprietary trading activity. So what happens? Trading activity diminishes. No close calls, please. Only maintain clearly justifiable positions. RENTD becomes DUVCID (Demonstrably Undeniably and Virtually Certain Immediate Demand). Who wants regulators parsing intent and second-guessing each and every decision? Just think of the compliance and reporting costs! All of these have the negative extremity of squeezing liquidity at a time when we are increasingly realizing liquidity is extremely important to the health of our markets.
Not to go on and on, but…take a quick look at this new European invention: the Simple, Transparent and Standardized Securitization (STS), which intends to define securitization that will carry lower risk-based capital charges than other securitizations. Having first deeply impaired, and in fact demonized the securitization business, they now want it to grow…but only exactly how the regulators wish for it to. Apparently, the Europeans have finally sussed out that Europe needs securitization to shore up its creaky banking systems. So what do card-carrying members of the Congregation of the Church of Regulatory Efficacy do? They pick winners and losers, of course. The STS rule includes detailed and complex criteria for what is and what is not an STS. One of the criterion requires that all financial assets securitized in an STS be self-amortizing. That means, amongst the losers is commercial real estate, because commercial real estate assets tend to refinance and don’t often self-amortize. Why would the ECB punish real estate, an asset class which is extremely important to the success of European economies? No idea. Permitting banks to apply lower risk-based capital charges on some assets is exactly the same as simply applying higher risk-based capital charges to others. What happens? One type of business increases and the other type decreases. I guarantee that Europeans will live to regret this decision.
The list of examples of governmentally-sponsored regulatory wounds to our economy could go on and on but let’s stop here. A lovely rebuttal to the regulatory instinct which birthed this litany of woe was Chairman Greenspan’s recent OpEd piece in the Financial Times, in which the maestro himself mused that, following the 2008 financial crisis, we’d have almost certainly been better off had we simply substantially increased bank capital and eschewed the enormous and confounding complexity of Dodd-Frank and its fellow regulatory travelers. Dr. Greenspan suggested that if bank capital standards had been raised to 20%, or even 30%, such capital levels would have solved the banking problem. He suggests that banks with that much capital at risk would be very careful, as were the private investment banks of old (general partnerships). I have spoken to some bankers who opined that they would be much happier dealing with substantially higher capital levels than the enormous complexity of Dodd-Frank, its introspection, its uncertainties, regulatory complexities, compliance obligations and the like. I have seen estimates that Dodd-Frank is costing the American banking system tens of billions of dollars a year (and 61 million paperwork hours over the past four years) just in compliance costs. Add to that the decisional uncertainty and the inability to execute reasonable business plans because of the ongoing and intrusive second-guessing from regulators (who appear to be just as baffled by their brief under Dodd-Frank as are the regulated) and the system begins to freeze up.
All this brings me back to a topic that we at CrunchedCredit have addressed repeatedly over the years: Our elected leaders can legislate almost anything they want, it seems (and if legislation will not suffice, an executive order appears to have little limit to its remit) but they can’t repeal the Law of Unintended Consequences. They cannot repeal Complexity. They cannot turn a quantum mechanics universe into a Newtonian automaton where pushing button A leads with certainty to outcome B. All prescriptive rules have unintended consequences. The more complex, granular and numerous the rules, the more unintended consequences. So some simple math: more + complex rules = more unintended consequences = more money + more energy + more time wasted in a hopeless effort to tamp down the negative externalities of these unintended consequences. At some point, systems collapse under the weight of this type of regulatory whack-a-mole, a notion someone in Beijing should have thought of by now (although the mere thinking of that thought may demonstrate severe lack of discipline, and we know what happens to folks charged with that!).
So let’s have some humility in policy wonkdom. Let’s embrace the notion that we perhaps don’t have the wisdom or foresight to micromanage systems that are more complex than we can truly understand.
That’s a prescription for broad, simple and understandable laws and regulations. Dr. Greenspan had it right — just increase capital, stupid. Stop trying to micromanage all the places where risk is addressed and returns are judged. Stop trying to pretend that a bunch of laws, rules, regulations and regulators can get it just right, like Goldilocks’ porridge. It can’t be done. When individual market participants make bad decisions, it’s bad for them. When the government makes everyone make the same decision, and that decision turns out to be a bad one, it’s bad for everyone. It’s not that power corrupts and absolute power corrupts absolutely (ok, it is, but that’s not the point here), but that the concentration of decisional authority through regulatory dictate destroys the multi-polar distribution of power, which is the very badge of working, free market economies. State planning doesn’t work (see: the USSR). Comprehensive, mommy state, interventionism and granular regulatory intrusion is state planning masquerading as the Rule of Law. However well meaning, it is a planned economy in sheep’s clothing. The “we know better” mentality of our government reminds me, as it did the editors of The Wall Street Journal in a recent opinion piece, of the EPA official from the Ghostbusters movie: intrusive, certain, undeniable… and wrong.
How many times do we need to suffer this lesson before we learn it?