by David Epstein & Sharyn O'Halloran
Does our financial system need a systemic risk regulator? Common wisdom is turning toward an affirmative answer to this question, but many doubt the wisdom of adding a new layer of bureaucracy to our already-Byzantine system of financial regulation. Plus, they say, markets already offer many ways to hedge risks, and traders should be smart enough to avoid these kinds of problems in the future.
But a risk regulator is the right way to go, and critics should take a lesson from post-Medieval British farmers.
Well into the 19th Century, English cows, sheep, pigs, and other livestock grazed on the “commons:” shared pastures which anyone could use. But the commons were always depleted, with barely enough grass to support the herds that used them, to everyone’s detriment.
Why couldn’t the owners conserve resources more rationally? In a 1968 essay, Garrett Hardin labeled this phenomenon the “tragedy of the commons” and outlined its basic logic. True, everyone is better off if fewer animals graze on the commons, but each individual user has incentives to increase the size of his herd past the socially efficient point. After all, the gains from these additions accrue solely to the one who adds a cow, while the costs are spread across all users. As a result, voluntary deals to restrain herd size fall apart, and all suffer as a consequence.
How does this relate to the regulation of financial systems? Well, from time to time markets are subject to panics, bank runs, and other system-wide failures. When these happen, the costs are borne by all members of the financial community, not to mention ordinary people who look to the banks for loans and financing for their projects. And these panics are more likely to happen when there are lots of risky assets in circulation. So all would agree that everyone is better off when banks restrain their use of risky assets.
But just like the English farmers, investment bankers know that if they add just one more risky bet to their portfolio, they will retain all the profits that result if it goes well, while the costs of systemic failure are spread out to everyone else. So they have incentives to add to their portfolio, as does everyone else in the system until – well, until what’s happening now happens.
Notice that the problem is not that the bankers aren’t smart enough to avoid trouble. Quite the reverse: trouble comes precisely because the bankers, like the herdsmen before them, are able to accurately calculate their own costs and benefits from alternative actions. And the problem isn’t the lack of risk management tools either: each bank can be individually safe and sound, hedging its own bets, while the system as a whole teeters on the verge of collapse.
How to escape the dilemma? We can’t do what the herdsmen did, which is fence in the commons and assign private rights to grazing land – no regulatory barrier could be high enough to prevent problems Wall Street from spilling over into Main Street.
How about the other extreme: regulate which assets can be bought and sold, to make sure that the system doesn’t have to take on unacceptable levels of risk? This puts the heavy hand of government right in the middle of the financial marketplace, which is surely a recipe for disaster. Since when are government officials better at measuring expected returns than bankers? And do we really want to force traders to get government approval before pressing the button on every deal? Business would fly away to foreign exchanges faster than you could say “Long Term Capital Management.”
But there is a middle ground: use market mechanisms to align the incentives of traders, making them face the true social costs of their actions. Buyers of assets with undiversifiable risk over a certain level would pay a fee into a central insurance fund, with the payment proportional to the size of the deal and its riskiness. Just like FEMA requires homeowners who build their houses on floodplains to buy insurance in the case of storms, financial firms would contribute to a rainy-day fund, to be used to stabilize asset values in the case of market meltdown.
This scheme would accomplish a number of purposes simultaneously. First, it would help ensure that banks don’t engage in transactions whose individual benefits to the investors are outweighed by the risk they impose on the rest of society. Second, it would create a stockpile of reserves, so that when the banking system does go into a tailspin, the money to bail them out (or at least the first installment) would come from the banks themselves, rather than the taxpayers. And third, it could get our financial system back in order using market incentives, rather than heavy-handed government interference, to do the hard work.
Moving in this direction will take resolve and cooperation from Congress, the administration, regulatory agencies, and most importantly the firms themselves. And there are still many details that will need to be worked out so that the system runs efficiently, without huge costs of oversight. But the rewards are great as well: a financial system that is well-regulated is a boon not only to borrowers and taxpayers, but, as is now abundantly clear, to the players in the financial system as well.
Agreed, and though I haven't read it all (I'm on chapter 2) http://www.gridlockeconomy.com/ from Prof. Heller of Columbia Law School provides some new thinking on the ideas of commons and anti-commons.
Posted by: Tom | March 08, 2009 at 09:37 AM