Economist: What Went Wrong?

An excellent piece of forensics from The Economist on the credit market meltdown, with some sage advice for regulators:

If altering pay cannot stop manias, can regulation? The criticism that this crisis is the product of the deregulation of finance misses an important point. The worst excesses in the securitisation mess are encrusted precisely where regulation sought to protect banks and investors from the dangers of untrammelled credit growth. That is because regulations offer not just protection, but also clever ways to make money by getting around them…

The financial industry is likely to stagnate or shrink in the next few years. That is partly because the last phase of its growth was founded on unsustainable leverage, and partly because the value of the underlying equities and bonds is unlikely to grow as it did in the 1980s and 1990s. If finance is foolishly reregulated, it will fare even worse.

For an alternative perspective, see former SEC Chairman Arthur Levitt’s op-ed in the Wall Street Journal on March 21st, "Regulatory Underkill" (stop and think about the word "underkill" for a moment). In addition to calling for measures that will increase market transparency for certain securities, he also alludes to structural change of regulatory agencies, although not the the extent that Rep. Barney Frank is calling for. Levitt writes:

Ultimately, those who were so concerned with Wall Street’s competitiveness need to realize that the true competitive advantage of America’s capital markets has long been their high quality…leaders and policy makers need to put their ideological fixations aside and commit themselves to giving investors the levels of transparency and accountability they deserve and expect from the world’s strongest markets.

In our view, we agree wholeheartedly that quality count in attracting capital, and the rules governing the game are a critical determinant of market quality. However, comparative regulatory burdens count too. Levitt, Frank, and others would be wise to heed the insights of The Economist article quoted above, especially if the financial industry is due for an inevitable period of contraction, as heavier regulatory burden may only exacerbate the industry’s downturn.