Ending the Confusion over the Role of Financial Regulators
What purpose or purposes are financial regulators fit for?
This questions was never asked during or after the 2008 acute stage of the Great Financial Crisis. Rather, policymakers around the world assumed financial regulators could prevent everything from fraud to another financial crisis. Under this assumption, policymakers passed legislation like the Dodd-Frank Act in the US that greatly expanded the financial regulators’ proactive role.
But is this assumption accurate? Are financial regulators actually fit for this or any expanded proactive role?
No! No!
The assumption is flat out wrong. Financial regulators are absolutely not fit nor should anyone expect them to be fit for a proactive role!
There are two reasons the assumption is knowably wrong:
Financial regulators are not and should not be in the business of allocating capital;
Financial regulators are not and should not be in the business of preventing the failure of individual firms.
Using these reasons it is time to debunk the myth financial regulators could successfully handle a proactive role.
Let’s consider the role of a bank examiner. The bank examiner is trained not to be involved in the bankers’ decisions as to what loans or investments to make. They are trained to look at the loans and investments after they have been made.
Why are they trained this way?
There is a belief private bankers reflect the market and therefore do a better job of allocating capital. There is no reason to think or research to show the government does a better job of allocating capital.
If an examiner approves or disapproves of a loan or investment before it goes on the bank’s books, it is the government through the examiner that is allocating capital. By design, bank examiners and financial regulators come in after the fact.
Because bank examiners come in after the fact, they also doesn’t prevent risk taking by the bank’s management. It is management’s decision how much risk to take in the loans or investments it makes. And it is this decision that ultimately determines if a bank thrives or fails.
As well known short-seller Jim Chanos put it:
If you’re an investor and you think the regulator is going to get ahead of the fraud, think again. Regulators are financial archeologists. They tell you after the company has collapsed what the problem was.
Financial archeologists don’t prevent fraud, they don’t prevent individual firms from failing and they don’t prevent financial crises.
But, but, but the financial regulators claim they are fit for their proactive role.
In her book Econned, Yves Smith debunks this claim:
The authorities now claim they will find ways to solve the problems of opacity, leverage, and moral hazard.
But opacity, leverage, and moral hazard are not accidental byproducts of otherwise salutary innovations; they are the direct intent of the innovations. No one at the major capital markets firms was celebrated for creating markets to connect borrowers and savers transparently and with low risk. After all, efficient markets produce minimal profits. They were instead rewarded for making sure no one, the regulators, the press, the community at large, could see and understand what they were doing.
So if opacity is intentional, have the financial regulators done anything about it?
They have done nothing since the acute phase of the Great Financial Crisis in 2008 to restore transparency to the global financial system. In fact, the global financial system is more opaque today than it was then.
Not surprisingly, financial regulators admit they don’t have the data needed to prevent a financial crisis and that opacity is still a problem.
In its recent Financial Stability Report, the Fed said:
A few recent episodes have highlighted the opacity of risky exposures and the need for greater transparency at hedge funds and other leveraged financial entities that can transmit stress to the financial system.
Please notice how the Fed is also trying to use opacity as an excuse for its failure as a proactive agent. If the Fed had the data on these risky exposures, it wants you to know it would have taken action.
In his most recent investor letter, Jesse Einhorn filled us in on what results when regulators are given a task for which they are not fit for purpose:
For the most part, quasi-anarchy appears to rule in markets. Sure, Dr. Michael Burry, famed for his role in The Big Short, reportedly received a visit from the SEC after tweeting warnings about recent market trends – and decided to stop publicly speaking truth to power. But for the most part, there is no cop on the beat. It’s as if there are no financial fraud prosecutors; companies and managements that are emboldened enough to engage in malfeasance have little to fear….
From a traditional perspective, the market is fractured and possibly in the process of breaking completely.