Let the Market Regulate Investment Banks

In the recent credit meltdown, the Federal Reserve has made emergency financing available to investment banks which is normally reserved for commercial banks. Treasury Secretary Henry Paulson says, according to the New York Times, that there will need to be more “oversight” (meaning regulation) of the investment banks since they are getting protections which used to be reserved for their heavily regulated commercial brethren.

Investment “banks” are companies like Bear Stearns, Morgan Stanley, Lehman Brothers etc. Although they have to follow the law and all kinds of SEC regulations, they are allowed to keep many more secrets than commercial banks and do not have to be transparent about their assets. They are also not subject to the kind of proactive auditing and examination that commercial banks undergo. They are, by design, more freewheeling than commercial banks are allowed to be. Often that freedom is a good thing and has made possible creative (in the good sense) financing of growth. Sometimes that freedom is a bad thing and it lads to creative (in the bad sense) financing of dubious (as opposed to risky schemes) and the invention of incredibly elaborate “investment” vehicles with a suspicious resemblances to Ponzi schemes which yield more in fees to the bankers than yield to the participants – especially once they unwind (the schemes, that is; bankers never unwind).

Paulson is right that the investment banks shouldn’t be allowed the backstopping services of the Fed (like the $30 billion credit line JP Morgan gets to help it buy Bear Stearns) without getting regulated in the bargain. If they get public “investment”, the public gets to protect its investment. But, IMHO, the solution is don’t give them the public help in the first place.

The prospect of market failure should be the regulator of the investment banking market. No matter what the short term pain, the country would have been better off letting Bear Stearns fail than bailing it out – and enriching JP Morgan further in the bargain. Yes, other investment banks might then have failed as well. Stock prices probably would have plummeted in the short term. On the other hand, investment banks might have become more creative in working things out with the homeowners whose mortgages are underwater. Now the banks can take a tough line with the borrowers knowing that the Federal Reserve is behind them.

If we bail them out, we encourage irresponsible behavior so we then need to regulate. But regulation discourages risk taking – and we need risk taking. We actually need investment banks. Moreover, regulation of the 24 hour worldwide online market the investment banks operate in is impractical. Regulators would have to slow the flow in order to watch it which would simply mean a faster exodus of the financial community to more hospitable shores. Only the lazy who like bailouts and regulation will be left here.

The market’s a cruel but effective regulator. It’ll remove the foolish (and the unlucky) and allow the wise (and the lucky) to survive even bad times. The prospect of failure will lead to an appropriate degree of both risk-taking (because you’ve got to make money) and caution (because you’ve got to survive). Might even be that without the prospect of a Fed bailout the banks would reduce executive compensation or defer bonuses until the long term consequences of short-term profits are more clear.

The best way to assure that the credit crisis is not quickly resolved is to shield investors in both houses and mortgages (and lots of other risky stuff) from the consequences of their actions. The best way to assure that the economy does not become robust again is to increase both regulation and bailouts.

The best course for the economy is to let failure take its toll and clear the decks for further growth.