Tuesday, October 07, 2008

Financial Fuss (5) - Regulation will Fail

Many commentators are claiming that the American financial system needs stronger regulation. They are totally unrealistic.

Government regulators will never be able to keep ahead of clever bankers. The current crop of regulators did not foresee the current problems. Only a few weeks ago, they were saying that the financial system was fine. If they were not clever enough to predict the credit crunch, how would they be able to come up with regulations that would have prevented it?

Most government regulations are designed to solve the last problem that occurred. They are usually incapable of dealing with the next problem, because they regulators do not know what it will be. You cannot regulate something that you cannot predict.

2 comments:

Gene Redlin said...

An innocent question John,

I live in Chicago. I was part of the whole Commodities and derivatives explosion twenty years ago.

When I first started trading commodities in the early 1970s there were no options, certainly no derivatives. No instruments comprised of instruments. Even some index trading was seen as suspect.

Now, 35 years later we have the fruit of what happened. Unringing this bell will be hard.

What you say about them bobbing and weaving to stay ahead of regulation is true.

On the other hand, isn't what just happened and the net result a little like killing the goose that laid the golden egg?

If there is no trading going on, all the gimmicks in the world won't work.

Maybe trading needs to outlaw options and many of the other things that have made trading a bad thing and go back to raw positions once again as it was in the 70s.

RonMcK said...

Gene
We need to be very clear about this issue. Provided there is no deception and no coercion, buying and selling options or derivatives is not sinful. Buying and selling options or derivatives is not contrary to God’s law. In every trade, there was a willing buyer and a willing seller, so there was not coercion. The price was agreed freely between the seller and the buyer. These were intelligent people who understood what they were buying and selling.

It is a mistake to say that trading in options or derivatives is evil or morally wrong. We must not ban what God has not banned.

The problem in the current situation is that many banks and hedge funds took positions in the market without thinking through the implications of the decision, or what they would do if they were on the wrong side of the trade. They assumed that house prices would go up for ever, or that cheap short term credit would be available for ever. When their assumptions proved to be wrong, they got into trouble. And if they were leveraged 30 to 1, their woes multiplied.

There is nothing wrong with selling risk. For a farmer or business that is a sensible thing to do. For other investors buying risk in exchange for a higher return also makes sense. There actions are sensible provided those involved no what they are doing. The problem in this situation is that many banks thought they had sold risk, but did not realise that all they had done was transfer it to a subsidiary. Likewise they forgot that insurance is not a total guarantee, because the risk that the insurance company might default always remains.

The problem is not with options, swaps or derivatives. The problem was with the foolishness of those who were trading them. Unfortunately, we cannot ban foolishness.