Jeffrey Friedman on Regulation

Clearly the regulators were predicting that steering banks' leverage into highly rated MBS would be prudent. This prediction proved disastrously wrong, but the Recourse Rule heavily tilted the field toward banks that went along with the regulators' prediction. Heterogeneous behavior among competing enterprises normally spreads society's bets among the different predictions (about profit and loss) made by various capitalists. Thus, the herd mentality is a danger under capitalism, as under every other system. Yet regulation produces the equivalent of a herd mentality by force of law. The whole point of regulation is to homogenize capitalists' behavior in a direction the regulators predict will be prudent or otherwise desirable. If the regulators are wrong, the result is a system-wide failure. "Systemic risk regulation" may be a contradiction in terms.

Neither capitalists nor regulators can use crystal balls to avoid making bad bets. That highly rated mortgage-backed securities would be prudent turned out to be a very bad bet. But we all suffered because this bet was imposed by financial regulators on the whole system.

Jeff Madrick's response: What made the commercial banks dangerous was that they nimbly skirted regulations rather than abiding by them; they were able to do so by the use of their relatively new structured investment vehicles and other off-balance-sheet transactions, including trading in derivatives. A main cause of the crisis was precisely those over-the-counter derivatives, which were not regulated, and led many bankers, hedge funds, and investment banks astray by thinking they had adequately insured their investments and could take on more risk. (As an aside, going back a few years, this is why Citi group and JPMorgan Chase lent so much money to the likes of Enron and WorldCom, soon after to become the largest bankruptcies in American history.)