THE HAIR OF THE DOG / BARRON´S EDITORIAL COMMENTARY ( VERY HIGHLY RECOMMENDED READING )

Monday, October 26, 2009

EDITORIAL COMMENTARY

The Hair of the Dog

By THOMAS G. DONLAN

The delusion of managing unmanageable risk.

THE THREE BIG PROBLEMS WITH GOVERNMENT regulation of any industry are overpromising, overreaching and underachieving. As discussed here in other editorials this month, regulation lulls consumers and investors into a false faith in controlled risk. It prompts lawmakers and bureaucrats to expand their power beyond the bounds of reason, need or the Constitution. And it motivates those regulated to reach improper accommodations with their regulators.

All three regulated for many decades yet producing financial crises like hens produce eggs. Golden or leaden, we cannot cut off the supply of eggs without doing a mischief to the hens.

We hear that this time is different. President Barack Obama tells Wall Street that "in a financial system that's never been more complicated, it has never been more important to have a watchdog function like the one we've proposed."

Federal Reserve Chairman Ben Bernanke swears up and down that banking would be better off in the Fed's pocket, and vice versa: "Our involvement in supervision is critical for ensuring that we have the necessary expertise, information and authorities to carry out our essential functions as a central bank of promoting financial stability and making effective monetary policy."

Perhaps he should reconsider the role of government. Are we better off since the government took hold of banking?

Contrary Opinion

Bank of England Governor Mervyn King, a wiser if not cooler head, last week publicly doubted the power of new regulation to prevent bank failures. He suggested that because the biggest financial powerhouses are pitiful giants that can't help themselves, they should be broken up so their mistakes don't destroy the world economy.

"The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion," King said. He credited "the sheer creative imagination of the financial sector to think up new ways of taking risk."

King even hinted that the name for breaking up failed banks is, or ought to be, bankruptcy. Too bad he didn't push the idea further onto the stage.

After absorbing 13 months of hindsight and commentary to the contrary, we still believe that Lehman Brothers was the only insolvent bank treated correctly during the late unpleasantness. A court froze its assets and liabilities; it was broken up and its creditors eventually will receive a reasonably fair share of the remains.

Unfortunately, the finance ministers of every important country seem to believe in their own competence to manage unmanageable risk, which they call "systemic." Europe has agreed in principle to establish a Continental superregulator; other international bodies are bravely volunteering to assume more power as well.

This is not much more than the preservation and encouragement of insolvency, disguised for a time by regulation, while the world waits for inflation of currency to leak into the nominal prices of houses and other assets. Japan has been trying it since 1990; Europe and the U.S. aren't any more likely to succeed.

Don't Look Back

Citi Investment Research and Analysis released a report last month titled: "Regulatory Risk Is High: In addition to credit and interest-rate risk, one of the key risks for banks is regulatory risk." Who should know better than analysts working at what seems to be the world's biggest zombie bank?

The authors issued storm warnings for increased capital requirements, constraints on over-the-counter derivatives, position limits on commodity traders, creation of a Consumer Financial Protection Agency, limits on credit-card and banking fees and penalties, reconsolidation of off-balance-sheet entities and cramdown rules to force banks to reduce balances on underwater mortgages.

We leave the details -- and there are copious details in which the devil can hide -- to Citi's analytic squad, led by Keith Horowitz.

In general, such measures are richly deserved, justified by the foolish and vainglorious practices of banks, quasibanks, nonbanks, insurance companies, brokers, fund operators and their associated speculators. The industry deserves harsh punishment. Many of its members have no legs of their own to stand on, having accepted the government as their lender, shareholder and partner in extremis.

But a punishment does not guarantee repentance or amendment of life. The legislative and regulatory grinder now operating will not protect consumers from the banks, nor the banks from the bankers.

Reducing leverage, however much it may be needed, will reduce capital stocks throughout the economy. Even those who believe that financiers are leeches on the hide of industry must understand that production requires capital investment. Our economies have been running on capital created out of thin air; it will be difficult to keep them running in a vacuum. It would be justice to shackle financiers and the financial industry, but the results won't be pleasant.

Managers and investors are extremely conscious of risk. They want to minimize it or control it or hand it off to speculators. Custom-made derivatives have been and continue to be the best risk-management invention of the past century. Companies use them to manage prices of fuel, raw materials and finance. Like most inventions, however, some users overindulged, and failed to foresee all the consequences.

Words of the Sage

If the current political trend continues, abuses and advantages alike will be regulated out of existence. H.L. Mencken warned that "there is always a well-known solution to every human problem -- neat, plausible and wrong." Regulating problems out of existence is one such solution.

Remember that Mencken was unhappy and cynical about a far happier age. He was complaining in the 1920s about "the growth of paternalism in government, the idiotic multiplication of laws and the intolerable increase of jobholders."

How little progress we have made! As Mencken explained, "Error flows down the channel of history like some great stream of lava or infinitely lethargic glacier. It is the one relatively fixed thing in a world of chaos."

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