There is a certain category of weapon called “fire-and-forget”. Think of an artillery gun. Once you have sent it, the shell will land where it’s going to land. There is nothing more to do once you have aimed and fired. There are other kinds of weapons that require continued interaction after you pull the trigger. Guided missiles feed information to the weapon in flight to make it more accurate. You can target moving objects.
One way to characterize the 21st century is as an accelerating cycle of crisis and regulation. With every event, governments promulgate rules to ensure that “It” won’t be repeated. Often, in parallel, they address concerns about systemic fragility by bailing out losers. The cost of salvation is restriction. Global financial crisis? Dodd-Frank and TARP.
“The Dodd-Frank Act, signed into law in July 2010, spans 2,300 pages and directs federal regulators to burden job creators and the economy with more than 400 new rules and mandates.”
It’s always the War to End All Wars. Then there’s another war. The failure of regulation to reduce risk never brings with it any reconsideration of the rules in place. It just brings more rules. All the regulation is fire-and-forget. There is no follow-through, no subsequent assessment of results.
The logic behind this intervention is simplistic: if one regulation is good, then three thousand and twenty-six must be better.
As John Cochrane writes,
“Our basic financial regulatory architecture allows a fragile and highly leveraged financial system but counts on regulators and complex rules to spot and contain risk. That basic architecture has suffered an institutional failure. And nobody has the decency to apologize, to investigate, to talk about constraining incentives, or even to promise “never again.” The institutions pat themselves on the back for saving the world. They want to expand the complex rule book with the “Basel 3 endgame” having nothing to do with recent failures, regulate a fanciful “climate risk to the financial system,” and bail out even more next time.”
There is no dynamic assessment of effectiveness, no post facto evaluation. Regulators put the system under increasing strain after every failure of the regulatory regime to “spot and contain risk.”
At best, the regime seems to shift the risk from highly regulated entities (e.g., banks) to loosely supervised ones (e.g., hedge funds and private credit). AIG used to call this “regulatory arbitrage” before their addled avarice made that phrase unmentionable in polite company.
People say it’s the “Golden Age” of private credit.
“In the U.S., private credit is growing its capacity through nontraded business development companies, interval funds, and middle-market collateralized loan obligations. Direct lenders have tended to target traditional middle-market borrowers with $25 million-$100 million (or equivalent in euros) of EBITDA, but the growing trend for club deals has extended private credit's reach to larger and more diverse borrowers. Additionally, distressed and special situations funds--which represent as much as one-third of available capital--are waiting in the wings for rescue financing opportunities.”
Meanwhile authorities can’t even manage to oversee banks with well-understood risks without stepping on the rake of mediocrity.
Consider the bizarre case of Silicon Valley Bank. There was a run on the bank because of concerns related to plain-vanilla interest rate exposure. It wasn’t complex mortgage derivatives. It wasn’t offshore chicanery. It was interest rate risk, something that financial risk managers learn at the beginning of their careers. It is the predicate for all understanding of financial risk. It’s one thing to die of an exotic cancer. It’s another thing altogether to meet your demise from an infection caused by a paper cut, while you’re under the direct supervision of your general practitioner.
Fire-and-forget, indeed.
What’s more, it’s not as if we don’t have our fair share of frauds continuing to shake the system, for all the oversight that’s supposed to catch this. For example, there is Greensill and myriad startup fraud.
It’s almost as if the post-disaster rule-making bonanza is meant to punish us for the failure of the Poindexter regulators to catch the risks right under their noses. Stop making me hit you.
Politicians make these rules and everyone assumes that the new regime will end up making the system more robust. Instead, it makes the system more fragile. The regulatory pile-ons are highly complicated, making for difficult compliance and even worse supervision, all wrapped in a false hope that the latest version will make us better off somehow.
It’s a safe bet that the international financial system has come to the brink of outright collapse many times because of the planned implementation of some of these new rules, saved only by the intervention of old hands who knew exactly what this would do to the plumbing and who were able to refashion or de-prioritize the most naive new regulations just in time. Think of the movie Fail Safe but for the global banking system, instead.
The logic seems to be if some regulations make us safer, then more regulations make us impregnable. It never seems to work out.
By extension, it’s as if we think, we must avoid pain at all costs, so bailouts are the only option in time of crisis, while ignoring any behavioral distortions they may induce.
This combination leads to more risk-taking. Heads I win, tails I don’t lose.
Here’s Pari Passu on Substack talking about the current environment in credit investing:
“It seems to be a trend in credit/restructuring to push the limits until failure. Over the last few years, this has been via liability management transactions and finding ways to increase returns while impairing others in the capital structure.”
In this part of the fixed income markets, for example, a tremendous amount of contemporary business involves gamesmanship in which one party attempts to elevate their priority and increase their share of the pie using legal warfare that creates little to no economic value. They were enabled to do this by the looseness of credit documentation struck when the government was throwing money at everyone like it was their job. The scale of this crabs-in-a-bucket behavior is without precedent. J. Crew, anyone?
What the Pari Passu author describes is part of a broader phenomenon in which people will go to the edge to get rich quickly. Bubbles emerge in pockets of the market. Meme trading. Cryptocurrency “investing.”
Investors, seeing the incentives to take risk, particularly in the less-regulated pockets of the market, are taking more of it to juice their returns. In part, this is because there has been such extraordinary stimulus over the past decade that the tidal wave of created liquidity has crushed the returns they can earn by behaving traditionally. It’s also because the proliferation of bailouts has reduced the perceived cost of failure. Additional regulation provides the further delusion that systemic risks are, if not eliminated, reduced substantially. If something bad happens, well, there’s a bailout for that. But, in any event, disaster is unlikely because regulators. Don’t worry. Abdul is there to spot you.
We have reached the point where the regulatory regime has made the financial system more dangerous. The fiction of invulnerability combined with enthusiastic subsidizing of failure has increased institutional fragility.
Instead of laying down misguided rules on top of rules on top of rules, the principal consequence of which is the encouragement of risk-taking in an already brittle ecosystem, I agree with Cochrane. We should replace the current approach with a much simpler one that shifts the risk of failure on to individual agents in such a way that systemic vulnerabilities shrink. People respond to incentives. The collective shift in behavior at the level of the individual in response to being told that he must bear the cost of failure works for the general, public benefit in an emergent fashion, even as we encourage each entity to limit its own risk-taking and each organization to police its own counter-party risk. People shouldn’t assume that the cavalry will come riding to the rescue. They’ll have to look after their own business and they’ll have to watch out for their neighbors if they want to move to the frontier.
Here’s Cochrane again:
“The solution is straightforward. Risky bank investments must be financed by equity and long-term debt, as they are in the private credit market. Deposits must be funneled narrowly to reserves or short-term Treasurys. Then banks can’t fail or suffer runs. All of this can be done without government regulation to assess asset risk. We’ve understood this system for a century. The standard objections have been answered. The Fed could simply stop blocking run-proof institutions from emerging, as it did with its recent denial of the Narrow Bank’s request for a master account.”
One study of the economic impact of Dodd-Frank estimated that it would lop off $895 billion in GDP between 2016 and 2025. That’s a hefty price to pay. Was it worth it? Is anyone asking the question?
We are well beyond the point at which fire-and-forget is appropriate. We need a smaller number of guided missiles.