How much regulation do we need?


Photo: Arnaud Clerget. Source: Wikipedia

After the financial crisis, Congress enacted new regulations on the financial system. The concern was that big banks had gotten us into an awful mess through their reckless lending, so we needed to put new rules in place to make sure they never did that again.

Dodd-Frank has been in effect for over six years now, and it’s reasonable to ask if anything has changed. The logic behind most regulation is simple: our economy runs on self-interest and profits. Regulation tries to keep things within the lines—limiting systemic risk and concentration of power, and rooting out and punishing fraud. If professional ethics, self-regulation, and concern for reputation did the job, we wouldn’t need formal laws. But self-control isn’t enough. Every major economy is also a regulatory state.

But regulators are human, too. Regulations are enforced by imperfect, self-interested people, and the rules can get out of hand. It’s easy to write rules, but they often seem to be like old generals fighting the last war. Strict rules become outdated and the regulators themselves are hired by law firms that want to circumvent them. And the proof is in the pudding: before the crisis, people thought that unregulated hedge funds would cause massive problems. But in fact, regulated banks are what spread the financial contagion.


Illustration: Farcaster. Source: Wikipedia

Because both free markets and regulation are imperfect systems peopled by imperfect actors, we will never strike a perfect balance. Instead, the pendulum will swing from one extreme to the other. Under Obama, the focus was enacting new regulations. Now, the emphasis is on deregulation. Our financial system will continue to be imperfect, working well 95% of the time for 95% of the people. But a huge economy with huge banks will create huge risks.

Money is a social convention and financial rules will always be with us. Free markets do the best job of allocating resources towards their most efficient use; but the ride will always be bumpy.

Douglas R. Tengdin, CFA