Saturday, February 6, 2010

Greenspan On Bank Regulation

Forbes editor-at-large Geoff Colvin sat down recently with Alan Greenspan for a wide-ranging interview. Aside from Greenspan's self-serving comments about why he was justified in printing huge mounds of money that created the housing boom and general economic crisis, Greenspan had some interesting comments about bank regulation and what banks know about each other versus the information held by bank regulators:

...he doesn't believe tougher regulation by the Fed could have saved the banks. The problem in his view is that regulators would be much worse than the banks themselves at judging banks' counterparty risk. "I was on the board of J.P. Morgan prior to becoming Fed chairman," he says. "I knew what J.P. Morgan knew about Citi, Bank of America, Wells, and others. When I arrived at the Fed, I quickly learned that J.P. Morgan's knowledge of those organizations was far greater than what the Fed knew."

Once you think about this for a minute, it shouldn't come as a surprise, even though a government agency has an edge in collecting any data it wants by simply demanding it.

It is very valuable for banks to understand their competitors and their counterparties, and so they do so. A bank regulator, on the other hand, does not have the kind of knowledge of what data is important that comes from actually competing in an industry. The data he will collect will be that of an individual one step away from actual decision makers. To a regulator, the risks that AIG took on may have looked to be within certain bounds of pre-established safety guidelines. On the other hand, a firm like Goldman Sachs had an insider's view of what the real risk was, since they were selling AIG the risk. That's why Goldman bought so much CDS type protection based on a collapse of AIG.

Further, the agenda of a bank regulator is different from that of a competitor, a bank regulator,, blind to the costs of serving certain types of clients may began and end part of his focus on whether a politically favored group is actually receiving their "fair share of loans." Whereas a banker is most assuredly very concerned with the costs of doing business with different groups of potential clients, politically favored or not.

Bottom line: Regulators are always one step behind. To insure true discipline on banks, the decision of risk appetite must be left with the individual banks BUT the moral hazard safety net must be removed so that banks realize that they will be at risk if they make an error by placing funds where the risk of loss is great.

1 comment:

  1. This is a textbook example of what Hayek called "ptrentece of knowledge"...