Somewhere along the path of this crisis policymakers have lost touch with the basics of financial system design. This is a topic that every development economist and financial institutions specialist knows, well but one which is lost on post-modern financial scholars and macroeconomists.
The idea is that there exists an array of financial markets and institutions across the financial system. Each particular market or institutions performs a crucial task. While it doesn’t matter so much what any particular economy calls each institution, i.e., its legal name, the task, itself, is crucial to a well-functioning financial system.
Take, for instance, commercial banks. Depository institutions take deposits and make loans. As such, they make investments in things (consumer, small business, and commercial loans, among other things) that are very hard to value from the outside. At the same time, perform a crucial economic function of aggregating small short-term deposits to fund large, long-term loans. But those short-term deposits are brought to depository institutions by unsophisticated investors who spook easily. Hence, we regulate depository institutions to limit their risk and provide deposit insurance to keep depositors (and their money) in the financial system.
On the other end of the scale, we have financial markets. You can invest in anything in financial markets. The Securities Exchange Commission regulates markets and their primary participants (investment banks and broker-dealers) only for purposes of transparency. That is, you can engage in as much risk as you wish, as long as it is accurately and credibly reported. We assume there are sophisticated investors who can face the risk of loss and that investment banks and broker-dealers will pay the price for misdealing with their reputations and possible bankruptcy.
Between those two extremes are many other types of institutions. In the US, we have insurance companies, mutual funds, and finance companies, to name a few. Each faces intermediate degrees of regulation. Each poses varying degrees of market discipline. Each is an important part of the continuum of financial institutions, gradually spanning the space between safe depository institutions and risky markets.
Hence, contrary to many recent assertions, the SEC plays virtually no role in mitigating risk in the investment banking world, nor should it. Instead, the SEC relies on accounting rules and sometimes bond ratings to report various types of risk to investors. Depository institutions regulators, on the other hand, play a crucial role in restraining risk among depository institutions. Insurance regulators are in the middle, restraining risk using firewalls to safeguard some standard consumer products (like life insurance) while allowing the market to reign free in others (like, in many cases, GICs and SPDAs).
This view has important ramifications for policy today. Lehman and Bear can play all they want, but should be constrained not by depository institution-style functional regulation – telling them specifically what they can and cannot do – but by accounting rules and bond rating measures of risk. When they fail, they fail. On the other hand, Countrywide, IndyMac and WAMU – being functionally regulated – should never have been allowed to get as far as they did.
Assuming, however, that Countrywide, IndyMac and WAMU really did manage to actively fool their regulators, there exists a safety net for depository institutions in order to insulate the unsophisticated investors and borrowers from undue loss. The discount window and deposit insurance provide a backstop in case the hard-to-value depository institution assets run into trouble. Investment banks and markets have no such backstop, because transparent reporting is supposed to give sophisticated investors all the information they need to make rational decisions.
Perhaps we are temporarily bailing out investment banks and insurance companies because the information was not as transparent as we had hoped. That may be fine, but without improved accounting rules and bond ratings we have little hope of ending the crisis. Perhaps we are bailing them out because regulators permanently want more “turf” in their bid for power. That is not okay, because risk will just migrate to a new, unregulated, platform to blow up on us once again.
The problem is that we really don’t know why we are bailing out all these institutions. In fact, this week we chose to bail out some but not bail out others that are nearly identical. While bailouts might engender moral hazard, and the lack thereof a widespread retreat from risk, random bailouts confuse markets so that investors have no idea what to do. Such policy will certainly draw out the economic effects of the crisis for far longer than would otherwise be the case.
One can’t help but wonder what the IMF and World Bank, who deal with these types of financial market structure problems all the time, would think of US developments. They seem uncharacteristically quiet. For an idea, I recently asked an ex-IMF economist, who reminded me that “the way the IMF would [help the US financial system redesign] is though the Financial Sector Assessment Program (FSAP), which began around 2000 after the Asian crises. Most major countries have had one and many others too. The country can choose to have the resulting report published in full or just summarized. THE US HAS REFUSED TO HAVE ONE. Bush finally agreed, but only if the results are released after he has left office!”
I fear that we can expect bad financial markets policy to constrain economic growth for some time to come.