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The Effect of Regulation on the Financial Meltdown

October 11, 2008

Arnold Kling has an interesting post with additional data to back up his earlier observations that regulatory arbitrage is responsible for excessive mortgage securitization and ultimately some significant portion of the financial meltdown.

His implicit point (why not add a sentence or two and make it explicit!) is that regulators underestimated the risk of rated mortgage securities and overestimated the risk of normal mortgage loans held in a bank’s portfolio with the result being that banks were encourgaged by regulation to increase the risk in their mortgage portfolios.

This isn’t just an issue of poor regulation that better regulation could have addressed, but one that is inherent in these sorts of bright line regulations– because even if an omnicient regulator set the bright lines, there will always be marginal cases not correctly dealt with by the bright line rules. Of course, regulators aren’t omnicient so the odds of getting setting up optimal rules are pretty small (the degree of suboptimality may vary of course).

These aren’t dispositive arguments against ANY regulation because the moral hazard associated with deposit insurance makes regulation necessary. (Someone needs to watch the credit risk of financial institutions because insured depositors won’t.)

In theory the ratings agencies should have acted as a superior private alternative to government regulation and analysis of risk. I would be interested in knowing more about why the ratings agencies weren’t able to perform this function very well.

Lastly missing in this analysis is any discussion of the magnitude of the effects I describe above because I don’t know much about it. Does anyone?


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