Nouriel Roubini & Adam Posen:What about regulatory oversight?

The Global Credit Crisis: How Bad Will it Get? April 14, 2008

Nouriel Roubini - Professor of Economics, Stern School of Business NYU
Adam Posen - Deputy Director, Peterson Institute for International Economics

My main point is that in the last few years they [Unintelligible] approach to regulation supervision of the financial system as being one of stressing on one side, self-regulation, market discipline, internal risk model and risk management, relying on principles rather than rules. In public, as you know, imposes rules and there is a regulatory arbitrage, but independent of really swaying too much in the direction of laissez faire approach to regulation and supervision, I think that one of the outcomes of the crisis is going to be one of swinging something to the middle. And I think a swing to the middle is important because I think that frankly, I don't see self-regulation and market discipline occurring unless you have a system of robust rules that imply that if you don't self-regulate, then we're going to do something about it.

Because if you think about the whole system of incentives in the financial system, first of all, the way bankers are compensated with these agency [Unintelligible], shareholders and bankers that leads them to gamble for redemption and take too many risking good times, and the system of compensation's not going to change. If you think about the system of securitization, which essentially, you're transferring the risk and you're making income from a fee, and therefore, your incentive to essentially monitor the mortgage in the first place is not there. If you think about the fact that the former CEO of Citi put it, 'when the music is playing, you have to dance because the competitive pressure is such, that if you don't do so, you're losing compared to your competitors.' I think the entire financial market is set up for these credit booms, for these asset bubbles, and I think the bust of them in the last three occasions in the U.S., has led to a severe recession. In 1991, after the bust of the S&L bubble and the real estate bubble; then we had the tech bubble, another recession; and now we have another bubble, housing; but now the recession, and this time around it's going to be uglier. So these cycles of boom and bust are becoming bigger. This is not just a mortgage problem, it's a credit bubble, and we have to think about which system of regulation supervision does the job. In my view, we have done too much to the extreme of market discipline, and frankly, I don't see market discipline. I don't see internal self-discipline, it doesn't happen. So we need something [Unintelligible].

GARRICK UTLEY: Adam, as you follow-up on this, keep one other thing in mind. We're in the middle of Manhattan...

DR. ADAM POSEN: Right.

GARRICK UTLEY: Financial capital. The argument has been made "all more regulation makes New York less competitive vis-á-vis London or whoever," and that this is something we should take into consideration. Is there any validity to this, as you give your thoughts?

DR. ADAM POSEN: Well, I just first, want to praise my friend, Nouriel, who is indeed my friend, for...

GARRICK UTLEY: You guys make a big point about this!

DR. ADAM POSEN: No, no! It's because it's genuine. But on the regulatory point, I'm very much in Nouriel's camp. I think we did have a better active laissez faire policy, this is where the Fed let us down. It wasn't about low interest rates, it wasn't about the bubble, it was that the Fed, particularly under Greenspan, basically resigned the responsibilities. And it came to something that goes to this competitiveness point you raised, Garrick. Because what happened was, we had a period where increasingly, the [money central banks?] Unintelligible [close?] that Michael worked for, were seen as at a regulatory disadvantage. They were offering certain services and had certain amounts of capital and supervisor requirements, and there're all these non-banks or I-banks or shadow banks, whatever you want to call them, who were taking up more and more of the financial system and were not subject to those rules. And the constructive response, if we hadn't had such a laissez faire world view under Chairman Greenspan, would have been to go to Congress and say, "Let's level the playing field somewhere in between and let's deregulate some...let's put some actual scrutiny and supervision and capital requirements on the non-banks or the non-traditional banks." And instead, what happened was Greenspan said, 'It's absolutely inevitable that we there will be no competitive ability up with the non-banks; they'll just all move to the Cayman Islands or something, and so therefore, we're going to loosen as much as we can through discretion, the supervisory and the capital of the traditional banks.' And so what that ended up was, a lot of bank credit decisions. Now, there's this tendency for people to say it's about "skin in the game." That's a phrase I hate, that people use. The idea being the problem with securitization, that everybody took assets and they didn't keep them. It wasn't George Bailey saving some loan who knew Mrs. McGillacudy's mortgage, and therefore, when she needed to re-negotiate, she could come down and see George. And that was the problem. But that's really much too simple-minded. I mean, think about airlines, right? They have very big skin in the game. If a plane goes down, the pilot and the crew go down with it. And being more cold-blooded about it, the reputation of firms, of airlines, when they have crashes, take huge hits. And yet we still have the FAA go out there and check that things are properly wired. Or at least we used to, which again goes back to the laissez faire regulatory problem. So even if there's skin in the game, you can't leave it to just regulation; there has to be a certain amount of safety protection, consumer protection, as in the mortgage front.

And so finally on the competitiveness point, it is a chimera to pretend that, be it Citi, be it Merrill, be it Deutsche, they're condemned to lack of competition. They're condemned, if they have regulations, they'll be broken. What is wrong is when you still have public sector subsidize banks. And that goes to Nicholas's example of the Landesbank. And Michael sort of said this but I can be much more rude about it than he can, it wasn't just that oh, these guys sort of had the wrong credit assessment mechanism. It was, these people had no business being banks. They had no business model, they had a government guarantee, they had lots of money on [end?], they had to do something with it. They had no clue and so they might as well roll the dice. And so that's where you want to worry about competitiveness. It's taking out these public sectors' subsidized banks, be they in Germany, be they Fannie and Freddie in this country, and really making it clean who's in the public sector and who's in the private sector.