Deregulation was often blamed for the financial collapse, but the greater problem was the regulations themselves.  This is not to say that we should be free of regulations but that they should be carefully considered.  Good regulation should promote free markets with requirements for transparency, but the more that they seek to promote uniformity through more rigid  rule making the more they induce rather than inhibit systemic risk.

In the Wall Street Journal Peter J. Wallison writes How Regulators Herded Banks Into Trouble Blame the Basel capital standards for over-investment in mortgage-backed securities and now government debt. 12/3/11


First decreed in 1988 and refined several times since then, the Basel rules require commercial banks to hold a specified amount of capital against certain kinds of assets. Under a voluntary agreement with the Securities and Exchange Commission, the largest U.S investment banks were also subject to the form of Basel capital rules that existed in 2008. Under these rules, banks and investment banks were required to hold 8% capital against corporate loans, 4% against mortgages and 1.6% against mortgage-backed securities. Capital is primarily equity, like common shares.

Although these rules are intended to match capital requirements with the risk associated with each of these asset types, the match is very rough. Thus, financial institutions subject to the rules had substantially lower capital requirements for holding mortgage-backed securities than for holding corporate debt, even though we now know that the risks of MBS were greater, in some cases, than loans to companies. In other words, the U.S. financial crisis was made substantially worse because banks and other financial institutions were encouraged by the Basel rules to hold the very assets—mortgage-backed securities—that collapsed in value when the U.S. housing bubble deflated in 2007.

This does not mean that all regulation is counterproductive. Yet the way it is currently pursued under the Basel rules will—through encouraging future common shocks—make the financial system more, rather than less, vulnerable to systemic breakdowns. To create a stable financial system, regulators should encourage asset diversification and do away with the Basel risk-weighted capital system.

HKO Comment:

My preferrred definition of capitalism is ‘the competition of ideas’.  When regulators and lawmakers displace the competition of ideas with single ideas enforced from a single source a greater risk is induced if the ideas promoted from central planning are poor.  Without the constant competition of ideas we will not know what doesn’t work until very late in the game. In the aftermath of the great recession we have not addressed the real causes which are the increased complexity and central planning that actually makes our risks larger.  Little of this is addressed in the Frank Dodd Bill.