William J. Polley

John Jansen (Across the Curve) links to the administration's draft version.  Enjoy!

Felix Salmon sent me a note in response to my last post.  He's more optimistic that the new regulations will kill fewer trees and result in clearer and more focused information for the consumer.  Maybe so.  I do believe it would be possible to provide a better, more streamlined set of disclosure documents to the consumer.  I'm not sure it will happen.

It may very well kill fewer trees though.  One of the possibilities mentioned in the white paper is the use of Internet based calculators (see page 63) to help consumers understand what they are getting.

I've purchased two houses and two cars in my lifetime, and I understood exactly what I was getting.  And in each case, there was someone pushing the papers who was ready to explain each part.  Of course in each case, I made it clear that I understood, so there was no way that they were going to lead me astray.  Could a dishonest person have tried to lead me astray?  They could have.  And if I were not financially literate, they might have succeeded.

So there are (at least) two ways for the borrower to mess himself or herself up here.  The borrower may not be financially literate and be led astray by a dishonest agent.  Or the borrower might be financially literate and just get caught up in the madness.

Tell me how an Internet calculator is going to really protect either of these folks with any more certainty that the current system does?  A fast talking salesperson can figure out how to maneuver around the disclosure requirements anyway (just you watch).  And nothing is going to stop the financially literate individual who is just following the herd figuring it won't happen to him or her.

But I do think that financial literacy is a necessary condition to better consumer protection.  And that isn't coming from an Internet calculator.  (By the way there is paragraph mentioning financial literacy in the white paper.  But I've seen that sort of talk for years.  Talk is cheap.)

We're rearranging the deck chairs, folks.

One of the complaints about the Vista operating system is that it assumes the user is an idiot and asks you to confirm everything.  (There is a way to turn that off, however.)  I have a feeling that the new model for consumer protection in the financial markets will be similar--but without the ability to turn it off.  The worst case scenario would be that anyone who wants a loan will have to go through something like one of those web based corporate training programs that forces you to click through bunch of information, answer some true/false questions, and give you a certificate of completion.  Don't say I didn't warn you.

Lest I be seen as being too harsh, let me conclude by saying that the aim here is noble.  I am sure that they have the very best intentions in the world.  I'm also quite sure that they believe that what they are proposing will benefit the consumer.  They want to give the consumer more useful knowledge, and they think that they'll get it right this time where they failed before.  I say it's not that easy.  And all the Internet calculators in the world are a waste of time for that guy who just clicks through the information without really reading it.  How are you going to regulate that?

In the case of Vista, I'm sure that so many people just click "ok" when prompted for all those confirmations that they don't read them anymore.  It ends up being less effective that way.  I don't think that's what we want credit market regulation to look like.

Today's Washington Post gives us a glimpse of Obama's plan to restructure the regulatory environment.

The plan is built around five key points, according to a briefing last night by senior administration officials and a copy of the white paper obtained by The Washington Post.

The proposals would greatly increase the power of the Federal Reserve, creating stronger and more consistent oversight of the largest financial firms.

It also asks Congress to authorize the government for the first time to dismantle large firms that fall into trouble, avoiding a chaotic collapse that could disrupt the economy.

Federal oversight would be extended to dark corners of the financial markets, imposing new rules on trading in complex derivatives and securities built from mortgage loans.

The government would create a new agency to protect consumers of mortgages, credit cards and other financial products.

My response goes something like this.  We live in an imperfect world with imperfect regulations on financial markets.  Hence, there exist policies that would represent an improvement on the current system, but there are also many (more) ways to mess it up even worse.

It would be much easier if we could close our eyes, make a wish, and eliminate stupidity and dishonesty.  But since that won't happen, let's think about whether the Obama plan would represent an improvement.

Hopefully it would put a stop to the "too big to fail" argument.  Obama seeks to give the government (Fed) the ability to break up large bank holding companies that get into trouble.  But the only part of the white paper where this is directly mentioned (that I can find) is pages 74-76.  To say it is short on details would be charitable.  Granted, this is something where the rules would probably be written on the fly, but then, isn't that what we're doing now?  Is it enough to just say that we'll let the Fed do what it needs to do?  If we did write rules for this, could the end up being too constraining?  This is a really tough problem, and I don't think they've solved it.

On the plus side, the document does spend a few pages suggesting a larger role for the Fed in overseeing the payments, clearing, and settlement systems.  Now that's something that is actually within their proper scope of regulation anyway.  That seems like a winner.  (But also short on details.)

More rules on trade in derivatives is also something that I would support if done right.  I'll need to think more about what is the right way.

But the document also spends a disproportionate amount of pages discussing how to protect consumers from "financial abuse."  In fact, in my perusal of the document tonight, I see the most detail in this section.  Among other things, they would like to mandate that a traditional fixed-rate 30-year mortgage ("plain vanilla" as they put it) be offered alongside any other lawful mortgage products, and that the consumer be given the tools to compare the various products.

Sorry, I don't see this as making much difference.  We already have disclosure requirements that kill quite a few trees for every mortgage closing.  With all of the information shoved in front of the homebuyer, most people just shut up and sign.  Will giving them more information (as opposed to useful knowledge--which cannot just be given) really make a difference?  If you're an unethical mortgage broker, don't you think that there will be a way to game this system to your advantage (offering fixed-rate mortgages at exorbitant interest rates to discourage their use, for example)?

Yet this seems to be where the administration is focusing its efforts.

Fortunately, there was some other insightful comment on regulation today.  Arnold Kling writes in a guest column at the Washington Post:

In my view, the worst regulatory error was allowing bank capital regulations to be evaded. In the late 1980s, after many savings and loans had failed in the United States, international bank regulators developed the Basel capital accord. Although this was flawed in many respects, it did represent a formal requirement for banks to hold capital based on risk. Most assets required 8 percent capital. Some low-risk assets required 4 percent capital, and some government securities required even less.

Soon after the capital accords were rolled out, banks began to come up with ways to "game" the system. For mortgages, the two most important techniques were securitizing mortgages and creating off-balance-sheet vehicles. Securitization allowed banks to get large portions of their mortgage portfolios rated AAA, and these AAA ratings in turn lowered capital requirements, particularly after a revision to the capital requirements that was formalized on Jan. 1, 2002. The off-balance-sheet entities were an even bigger scam, because generally-accepted accounting principles (which the regulators copied) allowed the banks not to count the mortgage securities in these entities as assets at all.

All of this was done right under the nose of the regulators. An article in 2000 in the Journal of Banking and Finance,called "Emerging problems with the Basel Capital Accord: Regulatory capital arbitrage and related issues," was written by a Federal Reserve staffer. Although such scholarly articles always carry disclaimers that the contents do not represent the opinions of the Fed, it clearly showed an awareness of how banks were using techniques to evade capital requirements. The author rationalizes this in part by suggesting that without the ability to evade capital requirements, banks would have been less competitive in the market to finance mortgage loans or other low-risk assets.

I think Kling is on the right track.  If financial market regulation is like firefighting, then to prevent this sort of gaming of the system would be like starving the fire of fuel.  A different tactic than pouring water on the fire, but still effective--sometimes more so.

At Marginal Revolution, Tyler Cowen writes:

The broader point is this.  Better regulation comes through many years of experience and gradual process improvements, built upon some reasonable methods for imposing regulatory accountability.  That's how the FDIC got to be good at much of what it does.  Better regulation does not come from sitting down, waving a wand, and hoping that a new name or box will address the problem you are concerned about.  Keep that in mind next time you hear that "now is the unique moment," etc.

Well put.  Doubling or tripling the amount of paper shoved in front of a home buyer at closing won't do it either.  There should be changes.  But there really isn't any need to rush something through by the end of the year. We're not in danger of a repeat of the circumstances that laid the groundwork for the crisis any time soon.  So take some time and do it right.  There might be a few good ideas in the Obama plan, but there is also a lot more alphabet soup without a lot of details about how it will all work.

Felix Salmon calls it a bust as well.

A lesson in moral hazard.

Had there been no FDIC, I would have asked questions, sought answers, and depending on those answers possibly moved my money.

But asking questions, seeking answers, and moving all of your auto debits from one bank to another is costly.  And the fact that there is an FDIC means that the individually rational decision for me is to sit tight, not incur the cost, and trust the FDIC.

Of course, the fact that people don't ask questions is how trouble like this gets started in the first place.

And yet, the notion of deposit insurance has always struck me as a pretty good deal for the banking public.  How much would you be willing to pay to ensure that there is zero probability that you will lose money if your bank fails?

There are those who oppose FDIC on libertarian grounds.  Fine.  I understand the argument that it causes moral hazard and raises costs.  I get that.

I get it, and I accept it.  Always have and always will.

Thanks, FDIC.

On May 22, 2009, Citizens National Bank , Macomb, Illinois was closed by the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation (FDIC) was named Receiver.  No advance notice is given to the public when a financial institution is closed.