Banking Regulation And Knowledge Problems
For much of the past decade, Crispin Odey has been waiting for inflation to rear its ugly head. The fund manager has been positioned to take advantage of rising prices in his flagship hedge fund, the Odey European Fund, and has been trying to warn his investors about the risks of inflation through his annual Read More
January 19, 2016
The Federal Reserve regulates U.S. commercial banks using a system of risk-based capital (RBC) regulations based on the Basel Accords. Unfortunately, the Fed’s misrating of several assets such as mortgage-backed securities encouraged the build-up of these assets in the banking system and was a major contributing factor to the 2008 financial crisis. The Basel system of RBC regulation is a prime example of a Hayekian knowledge problem. The contextual, tacit, and subjective knowledge required to properly assess asset risk cannot be aggregated and utilized by regulators. An effective system of banking regulation must acknowledge man’s limited knowledge and place greater value on individual decisions than on top-down planning.
Banking Regulation And Knowledge Problems – Introduction
Despite much debate, economists remain strongly divided on the fundamental causes of the 2008 financial crisis. Although some blame the crisis on deregulation of the financial system, evidence shows that the number and complexity of financial regulations increased consistently in the decades leading up to the crisis.1 Clearly, increased regulation did not prevent the crisis, and many economists argue that faulty regulations actually contributed to the crisis. Studies show federal housing regulations (Justiniano, Primiceri, and Tambalotti 2015) and the Fed’s own banking regulations (Friedman 2011) drove the increase in mortgage lending and securitization that led to illiquidity in the banking system and a freeze-up of the entire financial system.
The most important development in banking regulation since the 1980s has been the Fed’s adoption of risk-based capital (RBC) regulation based on a framework proposed in the Basel Accords.2 The United States joined the Basel system in order to standardize its financial regulations with the international framework with the goal of preventing bank failures and financial crises (Bernanke 2007). The Basel regulations are intended to make banks safer, but as discussed in what follows, these regulations actually encouraged banks to increase, rather than decrease, their risk-taking activities. Regulators thought RBC regulations would help identify risky banks by differentiating types of assets according to their levels of risk (Avery and Berger 1991). This study argues, however, that regulators lack the practical knowledge necessary to accurately assess the default and liquidity risks of particular securities, insolvency risks of individual banks, and systemic risk in the overall banking system.
The problem of imperfect knowledge affects many types of government policy as discussed in works by Friedrich Hayek. Hayek (1948 ) describes how knowledge is readily available to the “man on the spot” but cannot be easily aggregated by central planners to be used in top-down management of the economy. The subjective and dynamic nature of knowledge requires that it be created and disseminated through the market discovery process. Hayek (1942) eschews the notion that such complex phenomena can be simplified into basic mathematical formulations, an idea Hayek dubbed “scientism” for its pseudo-scientific nature and the false confidence inspired in its practitioners. Hayekian knowledge problems are most obvious in the cases of socialism and central planning but also manifest in other aspects of the economy.
This paper considers the Hayekian knowledge problems inherent to banking regulation, and, in particular, to the system of RBC regulations based on the Basel Accords. First, we discuss the adoption of the Basel system of banking regulation in the United States, the implementation of RBC regulation, and how it contributed to the 2008 financial crisis. Next, we outline important aspects of Hayek’s theory of knowledge and the role the market process plays in knowledge creation and dissemination. We demonstrate the limits of knowledge in RBC regulation and how recent changes in banking regulation do not resolve its fundamental shortcomings. We conclude by proposing that if regulators hope to improve the effectiveness of financial regulation, they must come to terms with the realities of their limited knowledge.
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