The role of financial regulation
The Washington Post reports today that the Obama plan to step up regulatory oversight on financial institutions to identify hazards before they spiral out of control may backfire:
Financial experts say the perception that the government will backstop certain losses will actually encourage some firms to take on even greater risks and grow perilously large. While some financial instruments will come under tighter control, others will remain only loosely regulated, creating what some experts say are new loopholes. Still others say the regulation could drive money into questionable investments, shadowy new markets and lightly regulated corners of the globe.
But some experts warn that such a “systemic risk regulator” could unleash new hazards if it can identify certain companies as being too large to fail. This could create an incentive for firms to grow dangerously big so they can win a government guarantee against failure. If a company has the promise of government protection, its creditors might be willing to lend it money at below-market rates because of the reduced probability the company will collapse and they won’t get paid back.
The danger of this incentive is twofold. For one, a firm may be willing to take on more unreasonable risks. Second, if a company gets access to unusually cheap financing, its rivals are at a competitive disadvantage
Indeed much has already been said about the administration’s reluctance to take a tougher stance on the financial corporations. As if that weren’t enough, some analysts have concluded that confidence that Fannie and Freddie would be bailed out should they teeter on the edge of collapse may have enticed them throw caution to the winds:
In the view of many financial experts, that is exactly what happened to mortgage-finance companies Fannie Mae and Freddie Mac before the government seized them last year. Congress chartered both companies to provide financing to lenders to make home mortgages. Their debt didn’t carry the official backing of the U.S. government, but many creditors assumed the government would step in if the companies faltered.
That meant the interest rates Fannie Mae and Freddie Mac had to pay to borrow were just slightly higher than what the U.S. government had to pay. With access to cheap financing, the firms borrowed hundreds of billions of dollars and bought or guaranteed trillions of dollars in mortgages. Some of these went bad in recent years. Last fall, the companies nearly collapsed as a result, prompting the government takeover.
One may conclude the missing and crucial ingredient from all the proposed regulations thus far is deterrence. Or more importantly, whether harsher penalties should be imposed on corporations who make irresponsible decisions and have to be bailed out by the Treasury. It isn’t exactly rocket science to come up with undesirable penalties such as capping the pay of all top executives when their company has been bailed out. Or one which involves the government taxing a greater percentage of profits of the bailed out corporations for the next few years. Indeed, these possibilites don’t seem to be on the table. Why aren’t they?