Thoughts on financial regulation

I'm trying to collect my thoughts on financial regulation here:

MR points to Dealbreaker:
"It's a bit hard to remember on a day like this but just a little while ago the big concern among journalists and regulators was the systemic risk created by hedge funds? The SEC was trying to regulate them, journalists watched them warily and corporate governance types referred to them as cowboys operating in a wild-west without rules.

As it turn out, the really risks in the system were being created not by hedge funds but by boring old investment banks and insurance companies. Sure there have been hedge fund failures but none on the scale and with the repercussions of the recent failures of Bear Stearns, Lehman Brothers, and the government sponsored mortgage companies. Hedge funds might not have had all that many rules governing their behavior but their incentive pay structure seems to have regulated their risk far better.

Larry Ribstein thinks that maybe we should start paying attention to the kind of corporate governance reform that works rather than the kind the experts favor.

As odd as it might seem seven years after Enron, I think this is the wake up call for corporate governance. Despite all the regulators, independent directors and Gretchen Morgenson, big firms were taking catastrophic risks under the radar. And, yes, the culprits were the conventionally governed big corporations. "

Absence of regulation does not by itself imply absence of problems. Just because the hedge funds are relatively unaffected or were not the triggers to the current crisis does not mean that they may not be the triggers to the next crisis.

The history of regulation and financial crisis is like the game of whack-a-mole. We just do not know where the next crisis will come from. As soon as we shut down one source of crisis another one appears in its place.

All crises seem to share one common element: the expectations that prices of assets will continue to increase. When prices are driven by expectations so that a bubble forms, the popping of the bubble can have some nasty consequences. If there is to be any regulation at all then it is the expectations that need to be regulated. But, how can this be done when we do not know whether expectations as reflected in prices are unbiased estimates of the true prices?

The assumption that the current price of an asset is the best unbiased predictor of its value has its foundations in the the faith that efficient capital markets will price assets "correctly". We can do no better than the "wisdom of crowds" and this has also led to the creation of prediction markets. But what if the wisdom of crowds is wrong and when do we know it's wrong? In effect, then the regulation of expectations would naturally lead to regulation of asset prices which would then be the equivalent of throwing sand into the wheels of capitalism.

One avenue that may have been tried (but perhaps unsuccessfully - I have no knowledge) is an automatic stabilizer built into the regulation of the firms. When asset prices are high so that the valuation of the company is high, the firm is required to hold a larger proportion of its assets in cash. Two counter-arguments come to mind:
1. Holding excess capital in cash is a waste of resources when it can be invested, especially in boom times. What are the opportunity costs of lost returns on investments?
2. It is this kind of regulation that led to some financial derivatives being created that allowed firms to legally circumvent reserve requirements.

But if the firm does hold more of its assets in cash when its valuation is high, what then of the bank where the cash is held? Would the bank be required to increase its reserve requirements? Yes, if the bank is also experiencing an increase in valuation.

Still to be worked out:
1. What increase in valuation is required to trigger an increase in reserve requirements? A historical average of some sort?
2. Should a firm be exempt if it is experiencing idisyncratic growth so that increasing reserve requirements is only triggered when the entire industry experiences a significant increase in valuation?
3. Is it "good" to restrain idiosyncratic growth? After all, sometimes a company can grow beyond its means. Norm Brodsky at Inc. writes on how he grew his company into Chapter 11:

The temptation arose after I had achieved considerable success with my first company, Perfect Courier. It had been on the Inc. 500 list for three years running and was still growing. Part of that success came from a decision I had made early on to go after city and state government contracts. The gross margins on them weren't the greatest, but they were good enough, and the cash flow was totally reliable because the customers always paid. Accordingly, government contracts became an important part of the foundation on which I built my company.

Then I discovered the magic of acquisitions. I learned how to buy other companies, which allowed me to expand Perfect Courier much faster. As a confirmed growth addict, I cared only about increasing the top line. I decided that government work was a waste of time and that I should concentrate instead on making acquisitions. And that's what I did -- until I made the one, fateful acquisition that eventually pushed me into Chapter 11. (See "Groundhog Day," July 2001.)

4. Update: The role of mark to market - Thomas Palley via Economists View:
Application of mark-to-market rules in an environment of asset price volatility can create a vicious cycle of accounting losses that drive further price declines and losses. Meanwhile, capital standards require firms to raise more capital when they suffer losses. That compels them to raise money in the midst of a liquidity squeeze, resulting in fresh equity sales that cause further asset price declines.

Bad debts will have to be written down, but it is better to write them down in orderly fashion rather than through panicked deleveraging that pulls down good assets too.

This suggests regulators should explore ways to relax capital standards and mark-to-market rules. One possibility is permitting temporary discretionary relaxations akin to stock market circuit breakers.

An obvious comment on mark to market: Firm executives hate mark to market when the value of the securities they hold is falling and love it when it's rising. When it's falling they need to provision against the fall but when it's rising they can borrow against it, thereby increasing their leverage. Is this how we really want them to behave?

5. Firms can still circumvent regulation.

Update: It turns out that the suggestion of increasing reserve requirements in boom times is similar to Martin Wolf's suggestion of countercylical capital and margin requirements.