A decade has passed since the acute phase of the Great Financial Crisis and the question is finally being asked:  does financial regulation work.

The snarky answer is “NO!”.  After all, the failure of financial regulation resulted in the Great Financial Crisis.

The MBA answer is “It Depends”.  Specifically, it depends on whether or not the financial markets are solely dependent on the regulators for enforcing the regulation.  For example, the Transparency Label Initiative ended the dependence on the SEC to ensure transparency.  Investors can use the Label to ensure they can know what they own.  As a result, even if the regulators are not up to the task, investors can cover for this shortfall.

But what about regulations where the market is dependent on the regulators?  An interesting study on corporate misbehavior sponsored by the Institute for New Economic Thinking (INET) observed:

we find no evidence that regulations can effectively curb future corporate misconduct. Rather, today’s regulations are a strong predictor of future fraudulent behavior because firms are quick to adapt to the new rules and move their activities to unregulated areas, because regulators rely on explicitly laid-out rules to be able to identify and prosecute corporate wrongdoing, or because the new regulations have unintended consequences.

Shorter, corporate misbehavior happens behind a veil of opacity and unless regulators remove this veil they are not up to the task of preventing this misbehavior.

With this background, let’s look at a couple of examples of what PhD Economists have championed in the way of a regulatory response to the financial crisis.

First up is the Orderly Liquidation Authority.  In theory, OLA is a very sensible idea.  Under OLA, the government takes over a Too Big to Fail bank and then uses its living will to dismember it.  While under government control, depositors and the economy don’t have to worry about any disruption.  Not surprisingly, PhD Economists like it.

Unfortunately, OLA only works in theory.  In reality, there is zero chance it works.  Start with the fact these banks are opaque.  Then move on to the fact investors know when the value of an opaque security is called into doubt you run to get your money back rather than wait around to see what the ending might be.

But investors aren’t just going to run from the Too Big to Fail bank going through the OLA process, they are going to run from all the other opaque Too Big to Fail banks too.  Why?  Fear of contagion.  Who knows what the size of the losses these opaque banks have to the bank undergoing the OLA process.  The crucial point here is the market isn’t going to wait to find out if the regulators are miraculously up to the task of dismantling a Too Big to Fail bank.

Next up are bank capital regulations.  In theory, increasing the amount of capital decreases the cost to taxpayers from bailing out these Too Big to Fail banks.

Unfortunately, bank capital regulations also only work in theory.  In reality, even organizations like the OECD recognize bank capital is meaningless.  Why is it meaningless?  It is an easily manipulated accounting construct.  Regulators manipulated it at the start of the financial crisis by suspending mark to market accounting.  This overstated book capital and any related ratio.  The crucial point here is regulators would rather fiddle with than enforce the regulation.

It is pure derp to assert financial regulation will work.