Buoyed by past deregulation successes, Congress didn't want Wall Street regulators to interfere before the crash.

Question: What can we learn from the recent financial crisis? Robert Engle: Right. So, I think we've learned a lot from this crisis.  And I think one of the things is kind of what we've been talking about.  That when firms take a lot of risk, to some extent, they're taking risk beyond what they feel themselves.  In other words, when large companies take on risk, then they impose risks on the rest of the system.  And these are systemic risks and these systemic risks we never used to think were really that important, but as soon as we recognize how the financial sector -- the risks the financial sector takes on can impact the entire global economy, we realize that those risks needed to be controlled for the social good.  And reduced the systemic risks.  So we have a new push to understand systemic risk, where it comes from, how do you measure it, how do you regulate it.  And the financial regulation that has been discussed for a year in the U.S. and which is about to be put into place, I think, and which is being discussed in Europe and everywhere, the focus is very much on systemic risk that those are the risks that you want to spend most of your regulatory time worrying about.  So that leads us to regulating more carefully the largest or the most systemic risky companies and institutions. Question: Is deregulation effective for financial markets?Robert Engle: I think we're fooling ourselves if we think that regulators are going to be able to outsmart the bankers.  So, the task of designing regulatory reform is trying to make more or less foolproof regulation and that's one of the advantages of the systemic category where, if you can **** that some smaller number of banks or financial institutions are the ones to worry about, then you can give them more scrutiny and more attention, you don't have to have rules that apply to everybody.  And I think that you can do sort of what the Fed has often done, which is said -- called "leaning against the wind."  In other words, if you think that there's too much risk being taken and that the financial sector is being super heated, you can actually increase the capital requirements at that point.  When Greenspan, who'd had no appetite for regulating risk thought that things were getting out of hand, he coined the phrase "irrational exuberance" to cover it.  But all he had was talking points.  And with this new regulatory environment there would be more than talking points, there would be things that could be done.  I do think that the reason the regulators were asleep at the switch in part was because we have had so much success in the U.S. history with deregulation, it's done valuable things for the trucking industry, for airlines, for telecommunications.  We've expanded deregulation, gotten government out of one sector after another and I think that the Greenspan approach and the Cox SEC were in that tradition of let's deregulate and see what these markets do.  And one of the things they immediately observed is that these markets took off.  But they took off by taking more and more risk, which it turned out to be risks that the taxpayers were really taking.  So I think what we've learned is that deregulation is not as effective in the financial sectors where at least it can't go as far in the financial sectors as it has I some of these other sectors, and so I think while they were asleep at the switch, I don't think it was really just the regulators that were asleep at the switch, I think that they were appointed to be asleep at the switch.  And that Congress, Congressional Oversight wanted them to be asleep.  And so that it was really across the board.  It was just not that the regulators missed it.  They were appointed to not do anything.  Question: Will Americans post-financial crisis be smarter investors?Robert Engle: I think they're more cautious.  On the other hand, that was true in 2003 also, when they had run up the internet bubble in 2000 and 1999, and then all of a sudden it blew apart.  So, people were cautious for a while, but then they jumped on some other bubbles.  We had an energy bubble, and then we had the banking bubble, and those -- and I guess the housing bubble.  So I'm not really sure whether Americans are going to be better investors.
Recorded May 25, 2010 Interviewed by Andrew Dermont