Regulating Finance: The "Now We Know" Factor

There's little doubt that the financial sector is about to be re-regulated in a serious way. This is sorely needed, and the conservatives and libertarians who say that increased regulation of Wall Street is a bad idea because regulation can't solve every problem, forever and ever, quite simply have no idea what they're talking about. (I'm looking at you, David Brooks.)

Whatever regulatory reform we get will undoubtedly be watered-down, since the regulatory reform won't come until the worst of the crisis in the financial markets has passed, at which time the public outrage over the financial crisis—and thus the political will to re-regulate Wall Street—will have diminished.

However, that doesn't necessarily mean that practices on Wall Street won't get better. One of the biggest reasons we're in this mess is our underestimation of tail risk—for example, banks' risk models were/are based on limited historical data (which didn't include a period of financial panic comparable to today's), so banks systematically underestimated the possibility of a financial panic. This led them to lever up excessively, use untested derivatives to circumvent capital requirements, etc., etc. Regulators were also guilty of underestimating tail risk—risk weights under Basel II severely overestimated the effectiveness of credit derivatives in hedging risk.

Here's my point: Once this financial crisis has passed, the historical data used in risk models will include data from the current financial panic. The models will presumably estimate a much higher (and much more accurate) possibility of a global financial panic. That is, the risk models will be based on a much better understanding of tail risk. Similarly, regulators will also know much more about tail risk. Using derivatives like credit-default swaps to hedge risk won't reduce banks' risk weights under Basel II nearly as much, which will in effect increase capital requirements. We'll all benefit from knowing what a global financial crisis looks like. I call it the "now we know" factor.

So even if the regulatory reform of Wall Street is severely watered-down (and knowing Congress, I expect it will be), we'll at least get some benefit from the "now we know" factor.