In testimony before Congress last week SEC Chair Christopher Cox contended that the Securities and Exchange Commission was on top of the Bear Stearns problem at every step of the way toward Bear’s takeover by JPMorgan Chase. At no point, Cox said, did the investment bank’s reserves fall below what the regulations required, meaning that there was never an occasion for the SEC to intervene.

As to Bear’s demise, Cox argued that when there is a silent run on a bank, no amount of reserves will suffice. The rebuttal, of course, is that when reserves are perceived as truly adequate there will be no run on the bank.

What seems clear is that regulators, both public and private, have failed to monitor and control the U.S. financial system’s excesses. Financial regulation occurs not only through the Fed and the SEC (and other government entities), but also through private-sector rule-makers such as the stock and commodity exchanges and the bond rating agencies. The sub-prime mortgage difficulties of the past year seem to indicate a system-wide regulatory failure, raising the likelihood of bank bailouts at taxpayers’ expense.

What accounts for this apparent break-down in supervision? In a paper about to be presented at Cambridge University in a conference on financial regulation, Professor Edward J. Kane of Boston College links weak regulation in the U.S. to financial globalization.

Kane suggests that U.S. regulators turned a blind eye to the dramatic deterioration in recent lending practices because they feared foreign “regulatory competition.” The premise is that financial institutions can to some extent shop around for the regulatory regime that would benefit them most, in part by setting up off-shore affiliates in more permissive locations.

As a result, two reinforcing regulatory failures would pave the way to the subprime meltdown.

First, regulators put too much trust in the risk evaluations assigned by the bond ratings agencies—Moody’s, S&P, and Fitch. In practice, such “insider ratings” proved much too sunny, partly because the raters themselves were in on the gold rush, while it lasted.

Second, the risky new securities banks sponsored became, in effect, invisible. Once banks and their affiliates “securitized” sub-prime mortgages and bundled them into so-called collateralized debt obligations, the banks were allowed to park such CDOs in structured investment vehicles (SIVs) off the banks’ balance sheets, out of sight of the regulators. Yet the banks remained “responsible” for the CDOs. In short, some large banks (think Citigroup or, in the U.K., Northern Rock) had incurred much more risk than met the eye.

Was all this a one-time derailment or a recurring episode in the history of financial regulation? Kane makes a strong case for the latter view. One of his tables, simplified here, posits five stages in a common scenario of financial crises in which regulation (and government-subsidized lending to favored political sectors) play a causal role.

Five Stages of a Regulation-Induced Banking Crisis

1. Loss exposures increase at highly leveraged banks, who then seek safety-net subsidies tied to government promoted forms of lending (e.g., U.S. housing).

2. When problems upset financial markets, banks and regulators allow losses to be hidden by resorting to accounting trickery on bank balance sheets.

3. Stress is placed on traditional safety-net support mechanisms, leading to calls for public intervention and bailouts.

4. Public bailouts leave Zombie Banks (insolvent but open, as in Japan) and no real solutions.

5. The mess gets cleaned up, through bank closures and new banking rules.

Source: Adapted from Edward J. Kane, “Regulation and Supervision: An Ethical Perspective,” April 2008, Figure One.

What remains to be seen is how the current subprime debacle will play out in the U.S. Will there be temporizing (Stage 4) or a more effective clean-up (Stage 5), as happened in the savings and loan crisis in the early 1990s? How many more shaky securities will the Fed take off the hands of private banks? And how much will that cost American taxpayers?

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