The Impossible Success of Supervision

The nice thing about a crisis – and this credit crisis in particular – is that it mercilessly exposes weaknesses in the system. Some European leaders even think that the system itself is ill. But where are the vitamin tablets, the pills and the doctor? The vitamin tablets, i.e. the lowering of interest rates by 0.5% by the European Central Bank and the American FED earlier this week, had little or no effect. The pills, i.e. injections into the capital market, are keeping the system going but they don’t seem to be restoring it to health. And the doctor, i.e. the supervisor, actually came too late and had insufficient equipment in his doctor’s bag. ‘This will have to change’, government leaders cry.

What we are seeing here is the impossible success of supervision: the supervision has failed so let’s increase it. However, the supervisor hasn’t really failed and, secondly, we’re expecting too much from supervision. There are four reasons for this:

1. A supervisor always maintains a distance. This means that a supervisor can never be as up-to-date as the market players. There is a fundamental information imbalance. A supervisor can only overcome this imbalance by either becoming a market player and/or leaving no room for the parties on the market to act independently. That would be really stifling.
2. Because of this information imbalance the supervisor is always too late when it really matters. The damage done by the credit crisis would have been considerably less if a supervisor had stipulated that subprime mortgages were no longer to be sold or traded. This is easy to say in hindsight, but how can a supervisor determine the right time beforehand? This is a timing problem.
3. Hindsight bias. It is easy enough to assess in hindsight that in a particular part of the market things were going wrong. The obvious thing to do is to more strictly regulate that part of the market. Obviously the next crisis is not likely to come from this area, so where will it come from? Every crisis has involved a different part of the financial market: the dot-com crisis, the accounting scandals and the credit crisis... Incidentally, this doesn’t mean that we should ban the financial markets.
4. The supervisors aren’t only disadvantaged when it comes to information, creatively they are also lagging behind. The financial market draws in talent because of the high rewards. Making bonuses for bankers illegal won’t change that. This talent is very creative and anticipates the financial needs of various parties with new financial products. A supervisor can track this, but because of the information imbalance and the timing problem will always be too late to prevent derailing.

Conclusion: more supervision is needed, especially internationally coordinated supervision. However, we shouldn’t expect miracles nor expect that crises are a thing of the past. Without risk there won’t be higher returns and there won’t be higher returns without risk!