by Calculated Risk on 6/23/2009 08:19:00 PM

From Martin Wolf in the Financial Times: Reform of regulation has to start by altering incentives

Proposals for reform of financial regulation are now everywhere. The most significant have come from the US, where President Barack Obama’s administration last week put forward a comprehensive, albeit timid, set of ideas. But will such proposals make the system less crisis-prone? My answer is, no. The reason for my pessimism is that the crisis has exacerbated the sector’s weaknesses. It is unlikely that envisaged reforms will offset this danger.

At the heart of the financial industry are highly leveraged businesses. Their central activity is creating and trading assets of uncertain value, while their liabilities are, as we have been reminded, guaranteed by the state. This is a licence to gamble with taxpayers’ money. The mystery is that crises erupt so rarely.

Wolf discusses how it is rational for management and shareholders to gamble when the risks are asymmetrical (huge potential winnings, limited losses). And he argues that "creditors ... appear to have lent to a bank. In reality, they have lent to the state." He also discusses how tighter regulation isn't enough because the banks will find a way round the new regulations.

Wolf concludes:

Such a crisis is not only the result of a rational response to incentives. Folly and ignorance play a part. Nor do I believe that bubbles and crises can be eliminated from capitalism. Yet it is hard to believe that the risks being run by huge institutions had nothing to do with incentives. The unpleasant truth is that, today, the incentive to behave in this risky way is, if anything, even bigger than it was before the crisis.

Regulatory reform cannot end with incentives. But it has to start from incentives. A business that is too big to fail cannot be run in the interests of shareholders, since it is no longer part of the market. Either it must be possible to close it down or it has to be run in a different way. It is as simple – and brutal – as that.

Talk about pessimism.

Another financial crisis is unfortunately inevitable - all we hope to do with reform is to put it off for a couple of decades or more.