Who Would You Rather Trust: Bankers Or Regulators?

from the do-we-have-to-pick-one? dept

A simple model of banking regulation and, like, counter-regulation goes something like this:

• Regulators are conservative and dumb, and want to safeguard banks from bad risks even at the cost of preventing good risks,
• Bankers are aggressive and smart, and want to take lots of good risks even at the cost of taking some bad risks, and
• Sometimes bankers can find people to put up with their shit and sometimes they can’t.

“Put up with their shit” is meant in the broadest sense – Can banks defeat Dodd-Frank? Brown-Vitter? Is Lloyd Blankfein a hero or a villain? Jamie Dimon? Etc. – but one particularly interesting question is, if you’re trying to do trades that evade or bend or optimize or whatever regulation, will someone do those trades with you? You could write a history of recent finance with the answer to that question: in 2007 you could chuck all of your mortgage risk off-balance sheet via securitizations, in 2008 you … could not, and in 2013 if you’re looking for someone to provide regulatory capital relief all you have to do is call a Regulatory Capital Relief Fund. Six years peak-to-peak, same as the S&P.

You could probably use words like “bubble” in characterizing that cycle but I prefer the approach taken in this new NBER paper by Guillermo Ordoñez of Penn (free version here), both because it mathematically formalizes that basic model of regulation and counter-regulation in an interesting way, and because it is congenially cynical. As he puts it, “banks can always find ways around regulation when self-regulation becomes feasible, and it is indeed efficient for them to do so.” Bankers, of course, always think that it would be efficient for them to find ways around regulation. They only do so when they can find someone to trade with them.

The gist of the formalization is that banks can invest in “safe,” regulator-approved assets; in “superior risky” assets, which have a higher return than the safe assets for the same risk but which are not blessed by regulators¹; or in “inferior risky” assets which have a higher upside but more risk than risky assets and are mainly a way for banks to implement moral hazard. Good banks want to invest optimally and care about the future, bad banks don’t care about the future and sort of maximize moral hazard. How they invest depends on economic fundamentals: if things are good then they invest optimally because there’s no need to take excessive risks; if things are terrible then they want to take excessive risks.²

Banks are constrained by two things. One is reputation: investors will trust a bank with a good reputation – that is, an observed history of taking good risks – and will fund it using unregulated shadow banking. The other is economic fundamentals, which investors can observe too: if fundamentals are bad and everyone knows banks will take excessive risks, then everyone demands the safety of deposit insurance (and regulation):

Why do investors agree on participating in shadow banking if they understand that banks are trying to avoid regulation that provides a safety net against excessive risk-taking? A potential answer is that indeed regulation and capital requirements are useless. However, if this were true, why would investors run from shadow to traditional banking when they become concerned about the quality of collateral?

I argue that reputation concerns lie at the heart of both the growth and the fragility of shadow banking. Shadow banking spurs as long as outside investors believe that capital requirements are not critical to guarantee the quality of banks’ assets, since reputation concerns self-discipline banks’ behavior. When bad news about the future arise, reputation concerns collapse because reputation becomes less valuable, and investors stop believing in the self-discipline of banks, moving their funds to a less efficient, but safer, traditional banking.

Like I said I find this paper very congenial but that’s in part because I feel like some people won’t. It rests in part on the assumption that bankers can observe superior-versus-inferior risky assets, and that regulators can’t. This is pretty intuitive – bankers are paid (more!) to make optimal investing decisions, regulators are paid (less!) to prevent risky investing decisions – and perhaps empirically supported – but, y’know, bankers are wrong sometimes too.

Also fun is Ordoñez’s proposal for a solution that steers between the dangers of unregulated banking and the inefficiency of blunt-instrument regulation:

Another, ideal but unfeasible solution, is to just give a high subsidy to all banks, regardless of their reputation φ, conditional on their repayment of the loans [i.e. conditional on their not defaulting] …. This naturally increases the cost of default for all banks and then allows for more self-regulation. This solution has the same effects as an exogenous increase of μ [i.e. expected economic conditions], but how does one finance these widely available subsidies?

Hahaha that’s “the best way to make banks safer is to give them such huge subsidies that surviving and getting the subsidies is more appealing than taking the risk of failing and losing the subsidies.” That seems … politically challenging,³ and so Ordoñez has some other proposals.⁴

I don’t know, I stopped there. Today’s bank lobbying – against increased regulation, higher capital requirements, and reduced too-big-to-fail subsidies – seems pretty uninspiring after that, doesn’t it? The real challenge would be convincing regulators that what’s needed are bigger and better subsidies for banks. I’m sure somebody’s working on that.

Sustainable Shadow Banking [NBER, ungated February version]

1. This is the condition “bankers are smarter than regulators.”

2. That is:

For all fundamentals [below some minimum threshold] banks take excessive risk, even if … reputation suffers a lot from taking risks. Intuitively, future prospects are so poor that reputation concerns are irrelevant. Similarly, for all fundamentals [above some maximum threshold] banks invest optimally, even if … reputation does not improve from investing optimally. Here, future prospects are so good that firms are afraid of defaulting and getting a zero continuation value.

3. Though also, like, true? Cf. Gary Gorton on how banks historically accepted regulation in exchange for a “franchise value” coming from their monopoly on banking activity, and how shadow banking erodes that franchise value, as in this summary:

The second insight of Gorton’s on which this paper builds is the importance of statutory franchise value for the business model viability of at least some kinds of regulated financial entities. Where competition from unregulated entities is permitted, whether explicitly or de facto, capital and other requirements imposed on regulated firms may shrink margins enough to make them unattractive to investors. The result, as in the past, will be some combination of regulatory arbitrage, assumption of higher risk in permitted activities, and exit from the industry. Each of these outcomes at least potentially undermines the original motivation for the regulation.

4. Viz. to have bad-reputation banks pay for the subsidy (since they can’t shadow-bank anyway) and give it to the good-reputation banks (who do shadow-bank), which I don’t really understand (how does the regulator measure reputation?) but whatever that’s a minor quibble.

Other posts from Dealbreaker:

• Banks Not Especially Eager To Start Handing Out Mortgages To People With Credit Scores In The Low 400s Yet
• Ringleader Of Insider-Trading “Fight Club” Didn’t Want Any Sarcastic Comments With His Inside Information
• Expert: You Can Only Fire As Many Employees As You Have, And If You Do, You Will Have To Hire Others

Filed Under: banking, regulators, trust, wall street

EU Telcos To UN Regulators: Divert More Money Our Way And No One's Internet Gets Hurt

from the unfortunate dept

Back in June, we wrote about the European Telecommunications Network Operators Association (ETNO) and its "proposal" to basically tax the internet, which they're hoping the ITU will adopt later this year. The thinking here is not hard to figure out. These are old school (either state run or formerly state run) telco monopolies not used to having to compete or innovate. They look at the success of various internet companies, and get jealous and -- like the big entertainment legacy players -- start thinking "hey, some of that should be my money -- this is unfair!" And, so they come up with schemes and proposals like this -- trying to effectively get regulators to force a revenue shift from those companies that innovated and found business models that work, over to the lazy telcos who sat back, fat and happy with their monopoly, refusing to innovate. It reminds me of Andy Kessler's description of companies that create value vs. those that lock up value. One goes out and builds something new that the market wants... and the other runs to the government and asks them to put in place policies that divert revenue to them.

With that in mind, check out ETNO's latest proposal from ETNO for the ITU to consider (pdf) later this year. And you notice all sorts of questionable claims, all designed to basically say: we haven't adapted, and so regulators need to force money from actual innovators into our bank accounts:

The telecommunications market and the telecoms industry as a whole is undergoing a fundamental shift. Catalysed by the availability of higher bandwidth connectivity, new applications and services are being enabled that go far beyond the traditional services of voice calling. In both the consumer and enterprise segments, services such as Voice over IP (VoIP), social networking, instant messaging and the rise of ‘apps’ have changed the way customers use their mobile and fixed connections. This development is significant and telecoms operators need to adapt and rebalance their tariff structure between voice and data services.

While broadband definitely is a key "catalyst" note how they set this up so that they can claim that it's really all about them... and then how the "tariff structure" needs to be "rebalanced." It's not about how they need to rethink their own business models or innovate or anything along those lines. It's about asking regulators to divert money that others are making to them.

The aim of the ETNO proposal is to contribute to the achievement of a more sustainable model for the Internet. ETNO is not asking for increased regulatory intervention but aims to establish a reference for commercial negotiations. The current interconnection model has some shortcomings that need to be addressed. Today there is a huge disproportion amongst revenues and a clear shift of value towards players (Over the Top players -- OTT) who are not contributing to network investment. Traffic and revenue flows need to be realigned in order to assure the economic viability of infrastructure investment and the sustainability of the whole ecosystem. The revision of the ITRs offers a unique opportunity to propose high‐level principles for IP interconnection.

Yup. "More sustainable" means "more money to the telcos." "Disproportion amongst revenues and a clear shift" towards online service providers is basically "the folks providing the services that make our connections valuable are making more money than we'd like, and we deserve some of that." And the idea that they're "not contributing to network investment" is a red herring. The big internet companies pay a ton for the bandwidth they use. And that money goes to the telcos. If they're not investing it in their networks, then perhaps they should explore why. Any time you hear a company say that "traffic and revenue flows need to be realigned in order to assure the economic viability," you know you're dealing with a company (or industry) that has failed to adapt and is asking the government to bail them out by taking money from those who did adapt. To claim that this isn't asking for regulatory intervention is laughable, since the whole process is one giant regulatory intervention. If this was just about commercial negotiations, this wouldn't be an issue. They'd just go out and negotiate.

ETNO believes that the revised ITRs should acknowledge the challenges of the new Internet economy and the principles that fair compensation is received for carried traffic and operators’ revenues should not be disconnected from the investment needs caused by rapid Internet traffic growth. The ITRs should be flexible enough so as to further encourage future growth and the sustainable development of telecoms markets, while respecting the guiding principles that led to the successful development of the Internet: private sector leadership, independent multi‐stakeholder governance and commercial agreements. ETNO is certainly not asking for any change to the current Internet Governance model which is based on private sector leadership and multi‐stakeholder dialogue.

Whenever a company is asking regulators for "fair compensation," it's basically them saying "our business model is flopping due to changes in the market, and we need you to prop us up." If ETNO really isn't asking for a change in the current internet governance model, then, um, why is it asking regulators to "rebalance" things and change who gets what cut of the revenue?

ETNO wants to avoid decisions that would prevent new business models from emerging or that would hamper differentiated offers, hence limiting consumer choice. The risk of undesirable economic and technical regulation of operator rates, terms and conditions will be much higher if the development of the Internet continues to be jeopardized by the lack of sustainability and/or by the lack of end‐customer satisfaction.

ETNO members have reiterated on many occasions their commitment to an open Internet and to continue enabling consumers to access services and applications of their choice as well as being completely transparent about terms, conditions and limitations. As recognized by the European Commission, operators should not be prevented from developing differentiated offers based on customer needs, in addition to the best effort Internet. It is important to note that nobody will be cut off from the Internet as the best effort Internet will continue to exist and to evolve. New business models based on differentiated offers will ultimately create more choice for consumers.

This is very close to "nice internet system you got there... you wouldn't want anything to, you know, happen, to it, now would you?" Basically, if regulators don't divert more money from successful internet companies to lazy telco monopolists, well, then we might just have to "jeopardize" the network.

There's a lot more like that in there. They're trying very, very carefully to use the language of "internet freedom" and innovation, in order to then explain why the ITU should put in place a proposal that effective forces local regulators to divert money from the companies who innovate, to the lazy monopolists. This is one of the reasons why so many folks interested in keeping the internet truly free and open are quite concerned about ETNO's proposal. It's not designed to benefit the internet or to encourage innovation. It's just designed to divert money from those who innovate to the telcos who haven't had to innovate.

Filed Under: etno, europe, innovation, internet, internet governance, itu, money, regulators, telcos

French Lawmakers Trying To Regulate File Sharing Don't Know Much About It

from the required-classes dept

We've joked in the past that judges and politicians should be required to pass some sort of "class" on certain basic technology issues before they'll allowed to rule on lawsuits or create regulations having to do with technology. All too often we find that many of the problems created in the courts and legislatures are due to politicians simply not understanding technology. It looks like that's true around the world as well. Over in France, where politicians are pushing hard for a three strikes law, a reporter went and asked some politicians some basic questions to gauge their understanding of the technology in question -- and found that most had absolutely no clue. Combined with the fact that approximately 90% of people in a recent survey were against the law, and that the European Parliament has said any such law would be a violation of a user's civil rights, you have to wonder how politicians can possibly justify such a draconian law.

Filed Under: france, p2p, regulators, technology literacy

Google, Too, Chooses Lobbying Over Competing

from the is-that-so-googley? dept

Microsoft's increasing regulatory headache from the European Commission concerns its Internet Explorer browser that comes standard with Windows. We've said before that this investigation is prima facie silly given the vibrant and increasing competition in the browser market, but it looks like things are just going to get worse for Microsoft. First, it was Mozilla deciding to complain that Microsoft was creating an unhealthy browser market by bundling IE with Windows. Now, Google is jumping onto the bandwagon and arguing that Microsoft's policy limits competition and harms innovation.

This is primarily problematic because the browser market is anything but uncompetitive. Firefox has created what is widely considered a better product, and, wouldn't you know it, gained considerable market share around the world (as high as 30% in some regions). More recently, Google introduced its own browser, Chrome, that launched to accolades and much user adoption. By introducing regulators into the browser market, these companies will all be distracted from providing users with the best possible product.

But what's even more confounding is Google's involvement. Obviously the company desires control of most browsers so it can set the defaults in its favor, but it is increasingly obvious that Google should not be bringing regulatory attention to the Internet -- especially when it comes to antitrust questions. Although claims of Google's "monopoly" are as specious as Internet Explorer's, making noise about antitrust is likely to come back and bite Google, especially given the rising number of political enemies they have.

Filed Under: antitrust, browsers, bundling, eu, internet explorer, regulators
Companies: google, microsoft

Disappointing: Mozilla Siding With Bogus EU Antitrust Action Against Microsoft

from the just-go-out-and-compete dept

Last month, it seemed silly that EU regulators were pursuing Microsoft for antitrust violations in the browser market for bundling IE. It was clear that some of the initial complaints had come from Opera -- an also-ran in the browser market. However, it seemed silly because there is vibrant and growing competition in the marketplace. Firefox has continued to grow its market share, and in the past few years we've seen new entrants in the browser market from Apple and Google -- both of whom have established small, but significant footholds.

So, it's especially disappointing to read that the Mozilla Foundation appears to be siding with the regulators, complaining about Microsoft's actions. Obviously, Mozilla is competing with Microsoft in this space, so at a first pass it may seem in their best interests to lobby the EU to punish Microsoft. But it's disingenuous to say the least. Mozilla got where it did because it competed effectively. It built a better, more secure browser that many people made the choice to support over IE. In fact, Firefox's chief architect, apparently unaware of what his "bosses" were cooking up, seems to have recently contradicted the Mozilla Foundation's new position, where he admitted that he couldn't see how anyone with a straight face could claim that Microsoft's ability to bundle created a monopoly, noting that Firefox's success in growing marketshare showed that making yourself "demonstrably better" worked. Oops.

Filed Under: antitrust, browsers, bundling, eu, firefox, internet explorer, regulators
Companies: microsoft, mozilla

EU Regulators Can't Resist: Go After Microsoft For Antitrust Yet Again

from the punching-bag dept

Microsoft is becoming quite the antitrust punching bag over in Europe. After a years long fight concerning antitrust charges in Europe, Microsoft finally gave in and agreed to pay up. So, now the matter is over with, right? No, of course not. EU regulators are back at it, telling Microsoft that the company is probably violating antitrust laws by bundling Microsoft Internet Explorer with Windows. This seems like an odd issue to bring up now as there is increasing competition in the browser market. Firefox's marketshare has continued to climb. Google has entered the market with Chrome. Safari is gaining increasing life (in part due to the iPhone) and there are numerous other upstarts as well. The idea that Microsoft is somehow exerting undue influence on the browser market (a market that, for the most part, involves free software) seems rather odd. It seems to confirm the initial opinion that many had of the original antitrust lawsuit in the EU against Microsoft. It's more about a simple dislike for Microsoft than any actual antitrust violation.

Filed Under: antitrust, browsers, bundling, eu, internet explorer, regulators
Companies: microsoft

Real Regulators Aren't Magicians, And They Usually Screw Up

from the why-regulations-tend-not-to-work dept

Last week we noted that Larry Lessig wanted to get rid of the FCC, and replace it with an agency that was designed to get rid of regulations, rather than add them. As we noted, no matter what the good intentions of regulators who are tasked with deregulating, it's unlikely it would turn out that way. It wouldn't be long before lobbyists and corporate interests were able to turn the "deregulators" into regulators in their favor. Related to this, Tim Lee points us to a good old fashioned barn burning rant from Jim Harper that should be a must read for anyone who thinks that today's financial crisis shows why we need more regulation. Harper is responding to a conversation on a recent episode of Meet the Press where some commentators were discussing the Bernie Madoff fraud, and noting that it shows the need for "real regulators." Harper then points out that we have real regulators and those regulators fail, regularly. And that's the problem.

People who support increased regulations do so under the mistaken impression that such regulators do the right thing most of the time and are able to spot fraud and stop fraud. That's quite rare. What happens instead is that such regulators are very fallible, and often co-opted by the very industries they're supposed to be regulating. Real regulators don't work nearly as well as the imaginary perfect regulators we'd all like to see -- and they often give us a false sense of security. It's what makes people think that a scam like Madoff's couldn't happen. The "real regulators" were alerted to Madoff's questionable activity time and time again. The real regulators also stood by and didn't realize the extent of the problem in the mortgage market. It wasn't a lack of regulations that was the problem that resulted in the financial crisis -- it was the fact that people actually thought the regulators who were in place were protecting us from such a mess. Real regulators are a problem. Imaginary, platonic ideal regulators would be great, but they don't exist.

When regulators fail to address a problem ahead of time, when they regulate inefficiently, when they hand their rulemaking organs to the industries they are supposed to oversee, those are all the actions of real regulators. That's what you get with real regulation.

What Burnett meant when she called for a "real" regulator, of course, was "the regulator I can imagine." The regulators people imagine are foresighted, interested only in the public good, they're resistant to lobbying, and they run efficient organizations. But these characteristics are simply imaginary.

Watching discussions like these, you come to realize how legislation and regulation thrive on self-deception and the appeal to ego.

Thousands of people come to Washington and stay because they believe that they can design the ideal regulatory system. They think they know how to write a law or a regulation that works for everyone, that protects consumers, that doesn't pick winners and losers in the marketplace, that doesn't make the glaring errors that we see month in and month out on Sunday morning political shows.

(If only voters didn't elect the wrong guy. If only lobbyists didn't 'corrupt' the system. If only, if only, if only . . . .)

Alas, we're stuck with real regulators. They fail, and when people rely on them, the failures of regulation are magnified.

Filed Under: regulators