The Free Market’s Weak Hand

“Except where market discipline is undermined by moral hazard, owing, for example, to federal guarantees of private debt, private regulation generally is far better at constraining excessive risk-taking than is government regulation.”

That was Alan Greenspan back in 2003. This is little different from another of his famous maxims, that anti-fraud regulation was unnecessary because the market would not tolerate fraudsters. It is also a key premise of the blame-the-government crowd (Wallison, Pinto, and most of the current Republican Party), which claims that the financial crisis was caused by excessive government intervention in financial markets.

Market discipline clearly failed in the lead-up to the financial crisis. This picture, for example, shows the yield on Citigroup’s subordinate debt, which is supposed to be a channel for market discipline. (The theory is that subordinated debt investors, who suffer losses relatively early, will be especially anxious to monitor their investments.) Note that yields barely budged before 2008—despite the numerous red flags that were clearly visible in 2007 (and the other red flags that were visible in 2006, like the peaking of the housing market).


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However, one thrust of post-crisis regulation has been to attempt to strengthen market discipline. This is consistent with the overall Geithner-Summers doctrine that markets generally work close to perfectly, and that regulation should mainly attempt to nudge markets in the right direction.

David Min (the lead rebutter of Wallison and Pinto’s theory of subprime mortgages, which relied on a made-up definition of “subprime”) has a new paperexplaining why this is likely to fail. (The Citigroup chart is from the paper.) The remarkable thing is that market discipline not only failed to prevent banks from taking on ill-advised levels of risk, but also failed to even identify those risks until well after they were splashed all over the front page of the Wall Street Journal—like the credit rating agencies downgrading Enron mere weeks before it filed for bankruptcy.

Min identifies a couple of structural reasons for this failure—reasons that cannot be fixed simply by tweaking regulations here and there. One is that banks’ primary funding sources—whether traditional depositors or other financial institutions engaged in repo transactions—are relatively insensitive to the degree of risk in the instruments they hold. Another is that the key form of market discipline on large banks seems to be that exerted by shareholders—and shareholders like risk, especially when banks are highly leveraged (because they can shift downside risk onto creditors).

Ultimately, one of Min’s suggestions is that we simply cannot rely heavily on market discipline as a means of constraining risk-taking by financial institutions. This leaves us with relatively unfashionable tools like higher capital requirements and structural reforms (size and complexity limits). But that’s not nearly sophisticated enough for the Geithner-Summers-Bernanke crew.

This piece is cross-posted from The Baseline Scenario with permission.