Better regulation, not more, is the answer to avoiding market meltdowns.
Better regulation puts into place mechanisms to detect potential problems, without unduly restricting legitimate business practices. More regulation merely stifles innovation.
Governments can raise capital, but only markets can make it grow and create a productive economy.
Even before Congress attempts to revamp financial regulation, it must establish a commission, like the Brady Commission that investigated the 1987 market meltdown, to determine the causes of the current crisis.
Federal Reserve Board Chairman Ben Bernanke supported this proposition during his testimony before Congress last week while arguing in support of the Treasury/Federal Reserve plan to stabilize the financial markets and end the crisis. Regulatory changes are needed, he said, but only after a thorough review of what went wrong and why.
There are some obvious problem areas any such commission should examine. First, what was the role of Fannie Mae and Freddie Mac in creating the bubble, the bursting of which precipitated the crisis? How should the two institutions be changed?
Second, the financial crisis grew in part because of the creation of securitized and other complex financial products, many of which, because of their complexity, could not easily be valued, especially when some of the underlying mortgages started to go bad.
What role, if any, did the Financial Accounting Standards Board's fair value accounting standards play in the crisis?
Robert Herz, the FASB's chairman, said in a speech Sept. 18: “The concept of fair value, which was intended to help bring transparency, was scorned by some as a villain, exacerbating the turmoil, and heralded by others as a savior in revealing the problems on a timely basis.”
Fair value accounting requires that certain assets held by financial companies, such as CDOs, be marked to market. Sometimes there is no market — that is, buyers — for such investments. If there is no market, the FASB standard says, a bank must mark the investment's value down.
This contributed to the collapse of some of the major institutions. The problem with fair value accounting in the case of derivatives is that it assumes the market value is always the fair value, but that is true only if there is no information asymmetry. Perhaps better disclosure regulations might solve the problems with fair value accounting of derivatives.
New regulations must also address the problems in the underlying mortgage origination practices. Perhaps mortgage originators might be required to retain 5% of any mortgage they make to ensure they continue to have skin in the game and therefore will be more careful in originating new mortgages.
Any investigating commission must examine the role of short selling, especially naked short selling, in deepening the crisis. Did short selling ultimately cause the collapse of Bear Stearns Cos., Lehman Brothers Holdings Inc. and the near death of American International Group Inc.? If so, should new regulations aim to of prevent a feeding frenzy about wounded companies?
The SEC already has taken one step to improve a key element of transparency. It deserves praise for its order Sept. 18 to require weekly disclosure of short sales by institutional managers. With short-selling becoming a mainstream investment strategy, better shorting data would create a fuller picture of the market exposure of managers and greater insight into those that buy long and sell short the same stocks and market weaknesses. It is a better reform than banning shorting.
While a postmortem into the causes of the financial crisis is essential before any revamping of regulation is undertaken, that postmortem must wait until the heat of the discussions about the federal bailout has cooled.
The acceptance of risk is essential to the functioning of the markets and the economy, but no financial company can be allowed to take on so much risk that the combination of its size and risk can bring about a widespread financial crisis. Regulations must provide limits and early warning signals so that such an event can be avoided.