The Sources of Regulatory Failure

I read this paragraph from Floyd Norris and immediately had a concern:

Among regulators, a buzzword now is “countercyclical,” and efforts will be made to incorporate that into any new system. In essence, that says that regulators should force banks to take fewer risks when things are very good — perhaps by raising required capital levels — and to relax the standards when things are very bad and the world is desperate for credit. The current system tended to react to everything being good by concluding less capital was needed.

It turns out, though, that he got to my concern in the very next graf. When times are good nobody wants to take the punchbowl away:


We’ll see in some new cycle if that idea would really work. Would the regulators be willing to act when things are very good, as they failed to do in the last cycle? Some have doubts, among them Walter B. Kielholz, the chairman of Credit Suisse, who says he thinks governments are unlikely to support regulators if banks and customers complain.

Right after a giant blow-up is the time when regulation is least-needed. This year, the free market would probably avoid problems all on its own since the problems of too much leverage and too much systemic risk are at the forefront of everyone’s minds. But because they’re on the forefront of everyone’s minds, now is when enhanced regulation is most viable. When things are going well is when we need the regulation. But things going well will only increase the power and prestige of people who want to make the regulations more lax. Meanwhile, when nothing’s blowing up nobody cares about financial regulation except the interested parties. So we make them laxer when they ought to be more stringent, and support tighter regulation only when it’s least useful.