A Return to ‘Regulation by Deal’?

(Update:  Thanks, Glenn, for the Instalanche!  If readers want a further discussion of this, including a short response from one of the co-authors of the “Regulation by Deal” paper, David Zaring, go here.  One reason to look at that further comment is that it gives an approximate definition of “regulation by deal” from the paper.)

I have spent a lot of the weekend reading summaries – I grant, I have not yet read the text of more than a couple of bits and pieces in the derivatives materials – of the financial regulation reform bill.  (Here is a pretty good summary from the front page of the New York Times, Saturday, June 26, 2010, by Edward Wyatt and David M. Herszenhorn.  But if you are looking for a good graphic summary of the highlights, see this graphic, “The Hope and the Worry,” that accompanies the article at page A12.)

With regard to the bill overall, well, I share the concerns raised by the editors of the Wall Street Journal and many others.  Far from eliminating too big to fail, or too systemically connected to fail, etc., the bill instead enshrines it and all the moral hazard accompanying it.  Much of the important systemic risk stuff is left in the discretionary authority of the Fed, however.  This leads me to a particular question about it.

In a certain way, this seems like a return to the phenomenon that Steven Davidoff and David Zaring identified in an article early on in the crisis – the so-called crisis response of “regulation by deal.”  Meaning by that, regulatory actions taken on a deal by deal, firm by firm basis, running through, of course, Bear, Fannie-Freddie, and so on.  Does this new discretionary authority amount to a return to the policy of regulation by deal?  A certain amount of ‘regulation by deal’ seemed justified at the moment of crisis.  But very soon into the process of regulation by deal, everyone had to consider its limitations.

What was it, from a downside view?  There was already a toxic combination of liabilities in existence – triple whammy, simultaneously massive; yet widely diffused throughout the financial system; and yet also interconnected with one another so that one failure might trigger another in unforeseen directions – based around the assumption that in any moment of crisis, they would be put to the Fed. That is, lingering moral hazard and its mis-leveraged fruits, on the one hand.  And yet completely discretionary behavior by governmental authorities as to how they would respond to crisis in any particular firm  at that particular moment, on the other.  Presumably the freedom to respond to Bear but not to Lehman would choke off the moral hazard.  The problem was, given that the liabilities and the leverage that the moral hazard had permitted had already created rafts of really-existing securities with really-existing obligations, things could not be stuffed back into Pandora’s box simply by a policy that eliminated (supposedly) the moral hazard.

Even if the regulation by deal policy was the right way to re-center the market players around risk, that policy would have to act into the future, not the past.  The result was that, at least for purposes of addressing the crisis as it was then unfolding, it merely increased uncertainties without addressing the already-ripened fruits of moral hazard.  (I’m sure if I worked at it, I could come up with a One Ring LOTR metaphor here.  But I will refrain.)  Regulation by deal could not address the moral hazard, because the externalities comprising it had been created by a vast number of deals over years; suddenly putting back in the “threat” of not getting bailed out did not make any of that go away.  At the moment of crisis, it merely increased the uncertainty.  If you were a firm, you didn’t know whether or not you would get bailed out – but since you could not really unwind all the moral hazard assuming risks all at once, in the moment of crisis, there was no “compliance” behavior that could respond to the supposed incentive.  The only result would be the same risk as before since the relevant securities had already been created – and a new dollop of uncertainty.

My question is, does the discretion now handed off to the Fed return us to “regulation by deal”?  And is this a good idea or a bad idea?  After all, in favor of it is that if it truly resolved the moral hazard problem by introducing genuine strategic uncertainty as to the Fed’s actions for any particular firm, then if this is supposed to be regulation for the future, maybe it is a good idea.    Against it?  Well, to start with, the markets would have to believe it – and believe it in the context of everything else that is in the bill.  I don’t believe it.  In fact, I think the bill should have been titled, The Dodd-Frank Put.  I think it’s a bad idea.  But do you?

(I leave aside, for now, certain public choice consequences that seem to me highly problematic with regard to the Fed role.  I also leave aside the topic in this that I follow most closely, the details of derivatives.)

If David Zaring (David blogs at The Conglomerate, but I don’t see anything from him on the new bill as yet) has any views on this, I would be delighted to post them here as a guest post.