Let the market deter bad risks

The Federal Reserve and the Securities and Exchange Commission formalized earlier this month a working agreement that had been in place since the bailout of Bear Stearns investment bank in March, the first time in its history that the Fed had made its discount window (i.e., money to bridge a potential crisis) available to an institution other than a thrift or a commercial bank. The two agencies will share information about investment banks, which have until now been overseen exclusively by the SEC.

This could be seen as simply a minor bureaucratic adjustment except for one problem: William Niskanen - chairman of the Cato Institute and a member of the Council of Economic Advisers during the Reagan administration - said that taken in conjunction with other developments the agreement presages a move toward direct regulation of investment banks by the Fed.

This is an unnecessary step that could stifle innovation in the securities industry without providing the stability that some people believe regulation provides. In fact, such regulation could be an inducement to assuming the kind of risky investment that contributed in some measure to the mortgage meltdown.

To understand why this is so, consider a few basic economic concepts. The first is moral hazard. This occurs when the government acts as a backup to firms, ensuring that they don't go out of business, or that their creditors or depositors are not harmed if they do. But when people believe that "the government has your back," it can induce unusually risky behavior.

For example, federal deposit insurance may be an important protection for depositors, but it has also encouraged risky behavior by banks and other institutions. This was seen in the 1980s, when 1,600 banks and a third of the country's savings and loans went under, eventually costing taxpayers some $150 billion.

Regulation is designed to counteract moral hazard by assuring proper procedures and accounting methods. But banks are among the most heavily regulated institutions in the country, and that didn't prevent many from failing in the 1980s as they operated under even broader deposit coverage and loosened real estate lending rules. Regulators are only human and cannot foresee every possible kind of calamity that might occur, and regulation is seldom strong enough to overcome moral hazard.

Another way of encouraging responsible behavior is market discipline, which occurs when investors know their own funds are at risk. The risk encourages them to be especially diligent about the kinds of institutions they invest in. Generally, market discipline is preferable to government regulation, which induces institutions to lose some of the entrepreneurial spirit of innovation.

The ultimate example of market discipline is failure of a firm that has been mismanaged or made unwise decisions.

One can make a case that commercial banks, or at least their depositors, should be protected against the risks of failure and therefore need regulation. However, investment banks don't make loans based on deposits. But they buy securities, which means they have collateral that can be turned into money when times get tough.

One could argue that it was necessary to bail out Bear Stearns because the market was so roiled by the mortgage crisis that this was impossible - though not everybody agrees. Whether it was really necessary or not, it was a unique circumstance. It hadn't happened for 70 years.

It has been argued that some securities firms are "too large to fail" because their failure would create ripples through the financial system that could bring it all crashing down, or at least create losses and undue instability elsewhere. However, during the 1990s, two major investment banks, Drexel Burnham and Kidder Peabody, were allowed to fail. The market accepted this with barely a hiccup and most people have forgotten even the names of these firms.

Treasury Secretary Henry Paulson and Fed chairman Ben Bernanke have both suggested that the Fed should be given additional powers to guard against what they call "systemic" financial crisis. However, this would create moral hazard in yet another industry, which could lead to even riskier behavior.

The special lending authority used to bail out Bear Stearns creditors is scheduled to expire in September, although Fed chairman Bernanke has hinted that it may be extended into next year. The best course would be to let it expire and rely on market discipline to deter unduly risky investment behavior.

Allowing the next investment bank that gets into trouble simply to fail would be a far more effective way to discourage risky behavior than having the Fed micromanage investment bankers.