The Worst Regulation in History? Jeffrey Friedman and Wladimir Kraus on the Recourse Rule
01/05/2012
It may seem, then, that the Recourse Rule offers us no lessons. It failed only because of unavoidable human ignorance. The regulators did not anticipate a nationwide housing bubble. Prescience about the bubble was rare, and nobody can be blamed for lack of omniscience. Testifying before the Financial Crisis Inquiry Commission, former FDIC Chair Sheila Bair expressed regret for the Recourse Rule and admitted that regulators had not understood the risks. Neither had most investors.
However, the danger of a fallible regulator is much greater than the danger of a fallible investor.
A prudent response to our fallibility is to spread our bets. The Recourse Rule contradicted this principle by encouraging all banks to invest in one category of “safe” assets. Herd behavior is always a danger in markets, but this particular herd was corralled by the regulators.
