Thursday, October 1, 2009

The Risk of Less Risk

As Ben Bernanke, the Federal Reserve Chairman testifies before Congress, we will come to the conclusion that there is risk, we should do something about it and we still have no idea exactly what. Referring to the problem as systemic risk, both in the creation of firms seeking to reach, through acquisition, the "to-big-to-fail" status and the inability of one agency to oversee every player in this complicated, global game of finance, Bernanke admits that we are far from where we need to be but much closer than we think.

There is absolutely no doubt in anyone's mind, this is bigger than one agency. Even the ability to provide oversight to this sort of mechanism creates a risk in itself. The Fed will admit it has learned a great deal.

Top of those now known facts is that numerous other participants in the financial world, those whose regulation falls under the purview of other agencies/regulators who, because it was not previously needed, failed to look at the leverage and risk some of their charges were assuming. Insurance firms and lending institutions that fell outside of what the Fed was trying to watch, slipped through the regulatory cracks. It is now known that these firms provided just as much in terms of financial disruptions as did the banking system.

President Obama has suggested that the central bank be the primary torch bearer in this effort to provide stability. The ability to understand the complexities of this type of problem should fall to those who can make the best decision. But the question of how quickly the Fed can react, outside of increased regulation and policing of the regulatory follow-through, has never been an attribute of this agency.

While the world has never experienced this kind of downturn, one where risk was sold as predictable and eventually collapsed under its own promises, the aftermath of such activity does justify the need for some reaction.

So how does Mr. Bernanke describe the harness he has determined is needed: consolidated supervision. This allows the Fed to take the lead and offer some much needed protections.

Many of the decisions the Fed makes are reactive. The Fed has proven in numerous circumstances that its decisions take weeks, often months to find their way into the system. This time-lag can be costly in a marketplace that responds to news now. It also relies on the predictive powers of the central bank, the ability of these bankers to spot the problem long before it becomes a problem and to move without causing a panic. Not exactly in the Fed's wheelhouse.

I'm not seeing how this could be done to the benefit of everyone concerned. Mr. Bernanke shows his concern as well: "Unfortunately, the current regulatory and supervisory framework for systemically important payment, clearing, and settlement arrangements is fragmented, creating the potential for inconsistent standards to be adopted or applied." Consumers will ultimately find this sort adoption of rules to be expensive.

As banks begin to anticipate the future of what these agencies adopt, pass down costs will further restrict any recovery in the short-term. The stock market, suffering from "yeah, but" syndrome, an affliction that allows you to second guess every piece of good news and discount every piece of bad, will not be phased. The markets will instead see this much the way they see the continued unemployment, limited growth because of it, and tighter lending requirements: a bump in the road.

But will any of these proposals eliminate systemic risks? Risk comes from uncertainty and the Fed is too smart to try and wipe away this sort of activity. Investors have to believe, if wrongly so, that the markets offer enough risk to warrant their participation. "Yeah, but" not too much that they get blindsided by something they could not possibly have anticipated.

We tend to think of investors on a personal level, believing that our participation in these risky endeavors is acceptable, even encouraged. Even after all we have been through, we still want to believe that somewhere, someone is watching over us. It is the comfort of this regulation, humming in the background that let us down and now, retooled, it is supposed to revitalize that trust.

So how does this play out in the long-term? Probably better than we might anticipate. Most businesses have become as lean as they possibly can. Their ability to borrow still remains more costly than it should and new leverage and capitalization requirements by both borrowers and lenders will make the process of regrowing the economy slower. Which is probably a good thing.

We have gotten swept up in the speed of business without allowing us the opportunity to examine motives and risks. The slightly slower pace that another regulatory door will provide should make the long-term health of the marketplace more welcoming. Money is returning to markets because it has no place else to go. To create a healthy investment environment, this has to stop. Money has to want to be invested, not forced.

The risk of less risk is threefold: a slower moving system, a more expensive system, and lesser short-term rewards for participation. The glory days are behind us and had anyone been able to see the future, they most assuredly would have suggested "yeah, but". But in the long-term, we could experience less severe downturns, more or better prolonged gains and a healthier retiree (at least from a financial standpoint).

The "yeah, but" syndrome will carry us forward for quite some time. But as all long-term investors know, we will soon forget. Let's hope those in the position to be the regulators don't.

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