Financial regulators regulate what they can see, not what drives fundamental risk

The result is a whole bunch of picayune regulations and interventions in the market that reduce efficiency, serve to obscure the real issues, and radically increase both complexity and unpredictability.  And because rules are made to be transcended, the more rules, the more opportunities for the well connected to rent seek at the expense of the ultimate consumers. Indeed the byzantine regulatory framework that we have with 8 different major regulators makes it even worse than that because it diffuses responsibility and leads to a cacaphony of confusing and conflicting messages.

It's hard to think of a system less capable of managing real systemic risk.  Because real systemic risk is really not visible to regulators because the risk only becomes evident when a crisis comes.  That is of course, the reason why bank collapses are called 'collapses' - no one in the market or regulatory apparat is expecting them until one day 'boom' the sucker goes down.  To think that regulators can figure out how to predict failure so that they can a priori ban or limit 'unsafe' practices presumes that the regulators understand the financial markets better than the full time players do and understand the institutions they regulate better than their managements do.

The best regulation is passive - banks will behave differently if they know they won't be rescued.  Or if they know that if the bank is rescued all of the Banks equity, preferred and deferred bonus pool owners will be liquidated with clawbacks for top management based upon spurious profits.  That type of regulation better aligns the real risks with the rewards - you behave in a foolish manner and you personally will suffer mightily.   But that is simple and doesn't meet with the modern 'progressive' bias for 'doing something, anything' to 'fix' the problem.  It also would severely limit the  opportunities for rent seeking, manipulation and power politics.  So we have 8 irrational and expensive regulatory agencies blundering around the body politic busily achieving nothing, lulling the people into an utterly unjustified sense of security.

So since they really can't achieve what they are tasked with doing they either do rather anodyne things like focus on risk capital 'adequacy' with adequacy not defined by what what will be 'adequate' for the next crisis because nobody has a freaking clue what that will be.  They also screw with functioning markets at the behest of rent seekers and activists with axes to grind.  High frequency trading is the latest example:  It is a 'consumer' activist bugbear and has cramped the trading anonymity of big institutional investors.  So the activists and rent seekers got together in Canada to get it effectively banned, leading to higher spreads for small traders.  Here's the details from Marginal Revolution:

These advantages were demonstrated in a recent natural experiment set off by Canada’s stock market regulators. In April 2012 they limited the activity of high-frequency traders by increasing the fees on market messages sent by all broker-dealers, such as trades, order submissions and cancellations. This affected high-frequency traders the most, since they issue many more messages than other traders.

The effect, as measured by a group of Canadian academics, was swift and startling. The number of messages sent to the Toronto Stock Exchange dropped by 30 percent, and the bid-ask spread rose by 9 percent, an indicator of lower liquidity and higher transaction costs.

But the effects were not evenly distributed among investors. Retail investors, who tend to place more limit orders — i.e., orders to buy or sell stocks at fixed prices — experienced lower intraday returns. Institutional investors, who placed more market orders, buying and selling at whatever the market price happened to be, did better. In other words, the less high-frequency trading, the worse the small investors did.

…In a paper published last year, Terry Hendershott of Berkeley, Jonathan Brogaard of the University of Washington and Ryan Riordan of the University of Ontario Institute of Technology concluded that, “Over all, HFTs facilitate price efficiency by trading in the direction of permanent price changes and in the opposite direction of transitory price errors, both on average and on the highest volatility days.”

The pdf of the paper is here. Here is the conclusion of a Charles M. Jones survey paper on HFT (pdf):
Based on the vast majority of the empirical work to date, HFT and automated, competing markets improve market liquidity, reduce trading costs, and make stock prices more efficient. Better liquidity lowers the cost of equity capital for firms, which is an important positive for the real economy. Minor regulatory tweaks may be in order, but those formulating policy should be especially careful not to reverse the liquidity improvements of thelast twenty years.

And now the usually level headed Michael Lewis of "Liars Poker" fame is evidently on a crusade against HFT, despite the hard evidence that it makes markets more efficient and therefore is good for consumers.  Here's a good review of his new 'expose'.  Indeed, it's hard to see how HFT can be bad when it has driven so much cost from the system.  The average cost of a trade in both transactions costs and spreads are lower since HFT's advent and when you take it away, they go back up.  This reminds me of the Feds accusing Rockerfeller's Standard Oil of monopolistic practices because the cost of refined products had fallen 90%.

Once again, regulators regulate what they can see, understand and benefit professionally from, not where the risk comes from - because disaster comes from what no one can see and and no one can understand........until it happens.

All in all another example of progressive 'logic' in action at our immensely wasteful and futile Federal Stupor State.