THE BIZOP NEWS

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Tyler Cowen, writing before the September 15th, 2008, on financial regulations states:

"In short, there was plenty of regulation -- yet much of it made the problem worse.

These laws and institutions should have reined in bank risk while encouraging financial transparency, but did not.

This deficiency -- not a conscientious laissez-faire policy -- is where the Bush administration went wrong."

This is the familiar economist's complaint: why if the risk was just more transparent, then rational or even reasonable people will moderate their risk taking.

There is little to recommend this view, either empirically or theoretically, as important to the overall problem.

Six years ago, Warren Buffett wrote correctly about the problem about derivatives:

"Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that layoff much of their business with others.

In both cases, huge receivables from many counterparties tend to build up over time.

(At Gen Re Securities, we still have $6.5 billion of receivables, though we've been in a liquidation mode for nearly a year.)

A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. Under certain circumstances, though, an exogenous event that causes the receivable from Company A to go bad will also affect those from Companies B through Z.

History teaches us that a crisis often causes problems to correlate in a manner undreamed of in more tranquil times.

In banking, the recognition of a "linkage" problem was one of the reasons for the formation of the Federal Reserve System.

Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn.

The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives.

In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain.

When a "chain reaction" threat exists within an industry, it pays to minimize links of any kind. That's how we conduct our reinsurance business, and it's one reason we are exiting derivatives."

Reputation is based on institutions which require interdependent oversight, and not mere transparency.

It is clear that a number of the entities operating in the shadow banking industry were operating in an institutional setting in which interdependent oversight and due diligence was sacrificed for speed and the booking of future profits today, with no thought as to who would pay the piper.

I would be much more impressed by Cowen's recommendations if a) he had a model of Dutch Tulip Suction ponzi in the 1630's, b) several testable ideas about regulation, and an empirical conclusion about what type of regulation would have prevented the Dutch Tulip Auction Ponzis.

I don't doubt that a lot of paper is produced by the Regulators - what I doubt is that we have a good model for ensuring interdependent oversight by participants in the general banking industry.