Regulation of Financial Services
After any serious hurt there is a call for immediate action in the political sphere. People look to politicians to protect them, and politicians are happy to encourage the notion. This rush to action overlooks the fact that even the management of the investment banks hadn’t understood the situation in time to avert their own losses. They are all very capable, highly functioning individuals but were unable to play out the head game of managing the risks effectively. There is little reason to think that regulators are better able to understand the issues and we have seen that the regulators both in the US at the SEC and in the UK with Northern Rock have failed to understand the pending emergency or to act. This does not prove incompetence but primarily points to the misplaced expectation that they would be able to.
There are more modest and specific areas which can be codified such restricting the scale of bond insurance / credit default swaps (CDS) for a given level of reserve. This would in reality restrict this market to a fraction of its prior scale but would make bond insurance a realistic private business. CDS contracts are not independent events and market slumps inevitably result in failures of those over selling insurance via CDS contracts. The staggering number and value of these contracts, given the level of reserves of the companies writing them, mean they are not enforceable as written and do not really have the value described without recourse to government bail outs.
The scapegoat of short trading is a cosmetic political issue similar to restricting profit taking on building supplies during a Florida storm. Its main purpose is to avoid news stories and resentment and its main effect is to reduce the motivation to assist in running an effectively priced market. People don’t like to hear that anybody has profited from a downturn but this can’t be confused with addressing the causes of the bad news.