Monday, April 16, 2012

What fails more than markets? How about regulations ...

John Carney reports:
Friedman and Kraus argue that regulation—especially regulation of bank capital under Basel II and similar rules in the U.S.—led to a homogenization of balance sheet assets across the banking system. Risk weighting loaded the dice in favor of buying the assets regulators viewed as safe—especially mortgage backed securities—and as a result the banking system as a whole was over-exposed to mortgages and lacked diversity.
This last point is especially crucial and not well understood. One of the advantages of a free market system is that different businesses can adopt different business strategies. In fact, competition encourages diversity as executives attempt to gain advantage over rivals in the face of an uncertain future. Disagreement among capitalists strengthens the system because it reduces the cost of errors. Some firms win, others lose, and the damage of bad bets is contained and balanced by the benefits of good bets. Regulations that impose one view on business create systemic risk, Friedman and Kraus argue.

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