My Two Cents

Thoughts on re-regulation

Chris Farrell Jan 25, 2009

How to regulate the financial system will be critical once we are past the crisis. One of the more thoughtful writings on the subect is by Clive Crook at The Atlantic. In Small World he makes a nuanced argument about the long-term war between financial regulation and financial regulation:

This decades-long compromise–an evolving and uneasy accommodation with the forces of financial innovation–has been smashed by the crash of 2008. But what comes next is far from obvious. The popular view that the current mess is all the fault of “deregulation” is misleading, at best. The implication that all we need do is return to an earlier era of stricter supervision is an illusion. To repeat, regulators did not choose to retreat; they were forced to. In the United States, Democratic administrations, rarely inclined to see deregulation as an end in itself, ceded at least as much ground as Republican ones. The main forces that spurred the retreat–the incentives to evade close supervision, and the technological opportunities to do so–continue to grow more powerful. So what do we do?

First, the financially sophisticated cannot be trusted to monitor themselves and each other–not to the extent that they have been lately, at any rate. They have made a hash of it, and the rest of us are now paying the price. Even if it means suppressing innovation, at significant cost to the rest of the economy, top-down supervision will have to be tightened. The scale of the present crisis will force a new balance to be struck.

Second, the idea that banks can be neatly segregated for regulatory purposes from other kinds of financial firms must be ditched. When firms that are not ordinary deposit-taking banks act in many other respects like banks–transforming short-term money into long-term money–they face the risk of collapses in confidence and bank-like runs. Moreover, they may be so big, or so interconnected with the rest of the financial system, that when they go bust they cause as much collateral damage as would big conventional bank that fails.

A new approach to financial regulation is already taking shape. The Treasury began to dissolve the distinction between banks and non-banks, for instance, when it widened access to emergency borrowing from the Federal Reserve–a privilege once held only by deposit-takers. Having extended the assistance they are willing to offer, the authorities must extend their supervision as well. The logic is the same as with deposit insurance: if you socialize the costs of failure, you have to regulate against recklessness. The broadening of intervention and supervision will need to go further.

There is much more to his argument. Check it out.

Boston University economists Christophe Chamley and Laurence Kotlikoff sent me this argument for a limited purpose bank. .

…Don’t let banks take risky positions. Make banks stick to their two critical functions – mediating the payments system and connecting lenders to borrowers.

To safeguard the payment system, banks must hold 100 percent reserves against their deposits either in cash or short-term U.S. Treasuries. With 100 percent reserves, banks runs will be history. This is not true of the current system, notwithstanding FDIC insurance. The FDIC’s potential liability exceeds $4 trillion; its assets are less than $50 billion. A run on the banks would require massive money creation and engender greater economic panic.

To ensure their second function – the uninterrupted connection of suppliers of and demanders for funds — banks should be limited to a) packaging conforming mortgages and conforming business loans (commercial paper) within mutual funds and b) marketing these mutual funds to the public; the model here is Fidelity, not Lehman.

Yes, this proposed banking system is not your father’s Oldsmobile. But Jimmy Stewart is not your banker. Some overpaid CEO thousands of miles away is deciding whether to foreclose your home and shutter your business. The clerk running your branch isn’t applying personal knowledge in deciding to lend you money or call your loan. He’s plugging your credit rating, collateral, and loan amounts in a computer and conveying the answer.

With the government ready to absorb losses, banks are talking outrageous risks knowing that Uncle Sam will cover them if things go south. Raising the trivially low capital requirements of banks, as Paul Volker’s Group of Thirty Commission just proposed, won’t change this behavior.

What will change this behavior is to not let it happen. Banks should be allowed to initiate only conforming, i.e., government-approved, AAA-rated mortgages and business loans. These would be long-term, fixed-rate loans with 20 percent-down and payments below 25 percent of income. The government, via the Federal Financial Authority (FFA), would use tax records to verify loan payment-to-income ratios. It would also spot check collateral. Once approved, the banks would bundle and sell “their” loans within mutual funds…..

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