Financial innovation and deregulation means expanding power, period.
When power expands exponentially and becomes more complicated, it requires an expansion of regulatory resources to monitor such activities.
Failure to recognize or prevent these potential hazards & failing to mitigate financial risk for the benefit of an insurance payout is gambling. Throughout history the financial industry has shown us that taxpayer funded insurance bets are breaking this nation. Speculative gains hedged against the US Taxpayer.
Such was the case with the Savings and Loan crisis of the 1980’s and FSLIC (Federal Savings and Loan Insurance Corporation). Regulators had neither the expertise nor the resources to monitor the activities of the Savings and Loan industry which left taxpayers holding the bag for tens of billions of dollars.
Instead of closing these insolvent S&L’s regulators adopted a stance of regulatory “forbearance.” They decided to refrain from exercising their regulatory right to put the insolvent S&L’s out of business.
There were three main reasons the S&L regulators (FHLBB Federal Home Loan Bank Board and FSLIC Federal Savings and Loan Insurance Fund) adopted regulatory forbearance.
First, the FSLIC did not have sufficient funds to close the insolvent S&L’s and pay off their deposits. Next, the FHLBB was set up to establish growth for the industry, so regulators were too close to the people they were supposed to be regulating. Last, the FHLBB & FSLIC preferred to sweep their problems under the rug and hope they would go away.
Regulatory forbearance increases moral hazard dramatically because an operating but insolvent S&L (nicknamed “zombie” S&L by Edward Kane of Ohio State because it is the “living dead”) has nothing to lose by taking on great risk and betting the bank.
If it gets lucky and its risky investments pay off, it gets out of insolvency. And as is likely, if the risky investments don’t pay off, the zombie S&L’s losses will mount, and the deposit insurance agency will be left holding the bag.
The relationship between voter-taxpayers and the regulator-politician is a particular type of moral hazard. A principal-agent problem which occurs when representatives (agents) have incentives that differ from those of their employer and act in their own interest rather than in the interest of the employer.
Regulators and politicians are ultimately agents for voter-taxpayers (principals) because in the final analysis, taxpayers bear the cost of any losses by the insurance agency. The principal-agent problem occurs because the agent (a politician or regulator) does not have the same incentive to minimize costs to the economy as the principal (the taxpayer). To act in the best interest of the taxpayer would require them to set tight restrictions, to restrict the holding of assets that are too risky and would not allow regulatory forbearance which allows insolvent institutions to continue to operate.
But, as you’d guess, regulatory agencies have little independence from the political process and are vulnerable to these pressures. By loosening requirements and pursuing regulatory forbearance, regulators can hide problems and hope that the situation improves. Edward Kane calls this “bureaucratic gambling.”
Regulators have an incentive to protect their careers by acceding to pressures from the people who most influence their careers. These people are not taxpayers but the politicians who try to keep regulators from imposing tough regulations on institutions that are major campaign contributors. Members of Congress have often lobbied regulators to ease up on a particular company that contributed large sums to their campaign.
In 1980 and 1982 legislation made it easier for savings and loans to engage in risk-taking activities. After the legislation passed, the need for monitoring the S&L industry increased because of the expansion of permissible activities. The S&L regulatory agencies needed more resources to carry out their monitoring activities, but Congress (successfully lobbied by the S&L industry) was unwilling to allocate the necessary funds.
As a result, S&L regulatory agencies became so short staffed that they had to cut back on their on-site examinations just when they were needed the most. In the period from January 1984 to July 1986 several hundred S&L’s were not even examined once. Worse yet, spurred by the intense lobbying efforts of the S&L industry, Congress passed the Competitive Equality in Banking Act of 1987 which provided inadequate funding to close down the insolvent S&L’s and hampered regulators from doing their job properly by including provisions encouraging regulatory forbearance.
As these examples indicate, the structure of our political system has created a serious principal-agent problem. Politicians have strong incentive to act in their own interest rather than in the interests of taxpayers.
Mishkin, F. S. & Eakins, S. G. (2009). Financial markets and institutions. (6th ed) Boston, MA: Pearson Prentice Hall
*see chart on p. 22 that lists top 25 Commercial Banks with derivatives; http://www.scribd.com/full/49199129?access_key=key-26rxk4eta6uhvcgqvuqx