Regulatory council to identify systemic risk won’t prevent another crisis, but still a good idea
According to the New York Times, the Senate and the White House are close to announcing a council of regulators whose focus is to identify systemic risk in the financial system.
This is a good idea. After previous financial crises, Congress enacted knee jerk, Sarbanes Oxley kind of legislation that added layers of compliance costs without adding any value to society. They seem to be learning, and there are apparently enough Congressmen with the sense to recognize that they cannot legislate away the next crisis by trying to legislate away the last one.
Senator Mark R. Warner (D-VA) showed some rare economic sense when he said: “You need a vigorous, focused group. You don’t need to create some massive new bureaucracy, but a place to share information and do some level of analysis.”
Admittedly an oversimplification, but the last financial crisis was mainly fuelled by asset inflation driven by financial innovation – financial products created in the last few years, sold by people with no economic interest in anything beyond the sale, and bought by investors who could not understand the risk. These products were not so much outside the existing regulatory system as they were above it, with different agencies responsible for regulating different parts but no regulator looking at the whole.
The Senate/White House plan will give the President and Congress the ability to say they have acted as a result of the financial meltdown, and may even help prevent another similar crisis, but shouldn’t add costly layers of additional regulation.
Regardless of what form the legislation takes, it is a certainty that there will be another financial crisis at some point in the next decade or so. The next financial crisis will be both similar and different to the last one. It will be similar in that some assets will be overpriced, with lenders willing to lend far more than is prudent. It will be different in that the overpriced assets will not be collateralised mortgage obligations. After the asset inflation, there will be a liquidity crunch precipitated by an unsuspected event. That event could be anything from a slowdown of growth in China, to a sovereign wealth default, to the realisation that some assets are fundamentally overvalued (a la dotcoms, tulip bulbs, or CMOs).
Therefore it is a certainty that no legislation will prevent every future financial crisis. However, a council involving several regulatory agencies whose brief is to look for systemic risk is far more likely to be effective than creating a Consumer Financial Protection Agency, or any other proposal I’ve seen so far.
