While the worst seems to be over for the financial sector, this is not a time for complacency or a return to business as usual. With the passage of the Dodd-Frank Act last July, US banking is entering a new era - but a workable system must be based on simplicity.
This legislation has only given the broad outlines of the new regulatory framework and will be a work in progress for the foreseeable future. Thus, it seems an appropriate time to discuss the design of effective financial regulations.
There are several considerations in this regard. First, Wall Street is wrong to fight tougher regulations. An innovative financial system is generally positive in the longer term, but the asymmetric nature of the macroeconomic costs and benefits in the under- and misregulated financial system of the past two decades has clearly shown that in the short and medium term, the benefits of a uncontrolled financial system can be outweighed by the costs of significantly higher leverage and vulnerability to financial shocks.
The basis for a workable system has to be simplicity, and its purpose has to be to promote effective risk management, transparency and accountability by changing incentives.
Moreover, the frequency and mounting costs of financial crises have a significant negative impact on economic welfare. Second, Wall Street is right to point out that an excessive regulatory burden can stifle the financial systems to the point of affecting economic growth. While crises move governments, regulators and bankers to action, rushing into reform can lead to solutions that are at best partial and, at worse, even more distorting than the status quo.
A system that works
The crisis has promoted a deep rethinking of the structure and role of the financial system, a shift from what I have called 'banking 2.0' of the past quarter-century to the new world of 'banking 3.0'. Moreover, while the focus today is understandably the prevention, or at least mitigation of future crises, regulation must also be directed towards ensuring the smooth and efficient functioning of the banking system in normal times. The search for safety can lead to a system that piles up capital requirements and stifles financial innovation, which can be as detrimental to long-term sustainable economic growth as one that is lightly regulated.
The basis for a workable system has to be simplicity, and its purpose has to be to promote effective risk management, transparency and accountability by changing incentives. My proposal is the following simple rules:
- Clearly separate the so-called 'utility' and 'casino' aspects of banking, with an explicit limitation of taxpayer support to the utility part of a financial institution. Such an objective can be better achieved by requiring that the banks set up separately capitalised subsidiaries to conduct market operations. Furthermore, both the risk-taking and the utility subsidiaries would be required to hold a meaningful portion of any securitised assets.
- Institutional investors, in particular pension funds and insurance companies, should be required to rely on their own internal risk-rating systems in fulfilling statutory requirements on asset allocation. Such a move would end the monopoly of the rating agencies, improve accountability and risk management, and limit the likelihood of events such as the credit default swaps (CDS)/collateralised debt obligation-driven subprime collapse of 2006-08.
- Put an end to Basel II and replace it by a simple leverage ratio (or even Basel I). The experience of the past decade with Basel II is not reassuring. The complexity of the system allowed for major loopholes, the gaming of the system by financial institutions and ultimately led to the uncontrollable growth of the shadow-banking system. The Basel Committee has made new proposals to complement Basel II. The sum total of these proposals, known collectively as Basel III, will pile on significant amounts of capital requirements but will retain the main elements of Basel II, which is risk-based capital allocation (although there is a leverage ratio on top).
- Require banks to hold minimum levels of contingent capital that would be converted to common equity if the bank capital falls below a benchmark level - the so-called 'CoCos'. Furthermore, banks should be required to self-insure through the creation of a large bailout fund that would go above and beyond the current Federal Deposit Insurance Corporation. Such a fund would be administered by the industry itself, with variable premia tied to the risk profile of the institution.
- Require that complex derivatives such as CDS be traded on organised exchanges such as the Chicago Mercantile Exchange. The standard exchange requirements of margin accounts, standardised products and collective responsibility would go a long way in bringing transparency and reducing systemic risk of these potentially toxic products.
Karim Pakravan is associate professor of finance at DePaul University in Chicago
