Apologies to readers.  I have been gone last week at my denomination’s annual meeting.  As I often say at this time of year, I never work harder than at that time, so please forgive my lack of posts.  As it is now, I am worn out, but at least I am home.  Home is my favorite place.

I am presently reading a book by Justin Fox, The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street.  So far, a good book.  He has a recent blog post that impressed me as well: Dumbing Down Regulation.

Should regulation be dumb?  In one sense yes, in others, no.  It really depends on how well the regulators understand the risks involved, and how much they can encourage professionalism among marketers and risk managers.  As those two increase, regulation can be smart.  “Follow these detailed rules to calculate the capital you need to be solvent 99% of the time.”

But when either of those two aren’t true, dumb regulation may be in order:

• Strict leverage limits, reflecting the worst outcome from underwriting poor quality loans.
• Disallowing risky types of lending, regardless of capital level.
• Disallowing liabilities that can run easily.
• Disallowing products that commonly deceive buyers.
• Disallowing certain types of contracts that fuddle accounting.

If everyone were smart, things could be different.  Deceiving people would not take place, and managements would not take undue risks.  Limits could be more loose, and products would be designed for discriminating buyers.

But, face it, we are dumber than we think, myself included.  Consumer choice is a good thing, though it implies that some will be deceived, no matter where one places the line of demarcation.  Along with that, some bank will not fit the rules and go insolvent, though it does not register so on the solvency tests.

My poster child for relatively good dumb regulation is the insurance industry in the US.  The industry is far less free-wheeling than the banking industry, and under most circumstances, the solvency margins are set high enough to have few insolvencies.  There is room for improvement, though:

• Make risk based capital charges countercyclical.  Perhaps tinkering with the Asset Valuation Reserve would do that.
• Have some sort of rigorous testing for capital relief from reinsurance treaties.
• Ban surplus notes in related party transactions.
• Ban all forms of capital stacking, especially where the transactions go both ways.  I.e., subsidiaries can’t own securities of any companies  in their corporate family.  All subsidiaries must be owned by the holding company.
• More rigorous testing for deferred tax assets.
• Assets as risky as equities, including limited partnerships, should be a deduction from capital.
• Securitized bonds that are not “last loss” should have higher RBC charges than comparable rated corporates.
• A standardized summary of cash flow testing results should be revealed.

As for the banks, they need to do that and more:

• Insurance companies list all of their assets.  Banks should as well.
• Intangible assets should be written to zero for regulatory capital purposes.
• Risk-based capital standards need to be tightened to at least the level of insurance companies, if not tighter.
• Some sorts of lending to consumers should be banned.  I am talking about complex agreements, that individuals with IQs less than 120 can’t understand.  Insurance policies have to be Flesch-tested.  Bank lending agreements should be the same.  If some argue that the poor need access to credit, I will say this: the poor need to get off of credit.  Credit is for the upper-middle-class and rich.  Poor people should not go into debt.
• Standardized summaries of terms and fees must be created for consumer lending, with large, friendly letters, and simple language that all can read.

What I am saying is that accounting has to be more conservative, and that regulators have to require larger amounts of capital to support their business, particularly at the banks.  Financial products must be made more simple for consumers to understand.  More transparency is needed everywhere, and if the financial companies complain, tell them that they will all be in the same goldfish bowl, so no one will gain an unfair advantage.

Dumb regulation bars certain lending practices, and raises capital levels higher than is needed over the long run.  So be it.  Smart regulation is far more flexible, and trusting that companies and consumers know what they are doing.  Unfortunately, when financial firms fail, there are often larger repercussions.  It is better to limit regulated financial companies to businesses where the risks are well-understood.  Let the less understood risks be borne by those outside the safety net, and bar those inside the safety net from holding any assets in those companies.

This entry was posted on Monday, June 29th, 2009 at 11:07 pm and is filed under Insurance, Macroeconomics, Structured Products and Derivatives, public policy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.