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By Michael Edesess
August 9, 2011


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The laissez-faire Western financial regulatory culture

In the first part of his book, Goodstadt claims the structural problems in finance that ultimately created the financial crisis were well known and frequently commented on by regulatory officials. He writes that their eventual upshot was foreseeable and preventable, but the prevailing regulatory philosophy and culture precluded action. He backs up this claim with direct quotes from financial officials. This may or may not prove anything, of course, since many observations were made publicly by many people, and it is possible to find every sort of concern voiced. It does, however, show that most officials believed that though there may have been problems, the market would sort things out, while regulation would only worsen the situation.

Goodstadt says this regulatory philosophy had become so deeply entrenched that it is not necessary to invoke the doctrine of regulatory capture to explain why regulators in the US and the UK regulated so lightly. It was not that they were doing a favor for the companies they regulated, in anticipation of eventual payback, as that doctrine indicates — it was that they actually believed regulation was bad.

One of the truisms frequently trotted out to reinforce this view was a common assertion after the market crashed, a version of which Goodstadt attributes to Alan Greenspan: “Officials could not be expected to have sufficient comprehension of financial markets to oversee them effectively.”

In other words, financial industry practitioners know their business better than regulators ever could, so they are in a better position to control it than regulators could ever be.

But issues of conflict of interest aside, whatever happened to the good old saying about “seeing the forest for the trees”? In her insightful book, Fool's Gold, Financial Times writer Gillian Tett makes much of the “silo mentality” of financial industry participants – most of whom hardly ever looked beyond their own areas of responsibility to consider how much risk exposure the whole chain, on which they were only one link, was causing investors and the financial system.

For that kind of overview, the system needs those for whom such perspective is in their job descriptions — regulators.

Moral hazard and too-big-to-fail

Surprisingly, Goodstadt also criticizes the ongoing Western concerns about moral hazards and the protection of too-big-to-fail banks as overwrought. He writes that according to studies, breaking up big banks into a larger number of smaller ones will not create a more stable financial system.

Though he doesn’t express it clearly enough, his point seems to be that if you have hands-on, interventionist regulators, you don’t need to worry about moral hazard. Moral hazard means that if you’ve bailed out banks before, they will take more risk because they know they will be bailed out again. But if they are subjected to tight regulation, Goodstadt argues, regulators will prevent them from taking that risk.

Goodstadt invokes former Obama adviser Lawrence Summers to support his argument:

Financial institutions can fail because they become insolvent. … But solvent institutions can also fail because of illiquidity, simply because creditors rush to withdraw their funds, and assets cannot be liquidated fast enough. In this latter case, the availability of external support averts needless panic and contagion.

This quote, interestingly, indicates a straightforward acceptance of the persistent possibility of market failure. In a perfect market, a solvent institution’s assets – its sound long-term loans – could be sold immediately for their fair values in the marketplace and the proceeds used to pay creditors. Summers’ statement admits that in crash conditions, the market cannot be relied on to recognize asset values and pay a fair price for them. This situation did, in fact, occur in 2008.

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