Some new proposals on the future of financial regulation were on VoxEU:
1. Luigi Zingales calls for, among other things regulation of the CDS and CDO market.
2. Charles Wyplosz summarizes The ICMB-CEPR Geneva Report: “The Future of Financial Regulation”. Some excerpts:
You can’t make the system safe by making each bank safe
The current approach to systemic regulation implicitly assumes that we can make the system as a whole safe by simply trying to make sure that individual banks are safe. This sounds like a truism, but in practice it represents a fallacy of composition. In trying to make themselves safer, banks, and other highly leveraged financial intermediaries, can behave in a way that collectively undermines the system.
As a result, risk is endogenous. Selling an asset when the price of risk increases, is a prudent response from the perspective of an individual bank. But if many banks act in this way, the asset price will collapse, forcing institutions to take yet further steps to rectify the situation. Responses of the banks to such pressures lead to generalised declines in asset prices, and enhanced correlations and volatility in asset markets.
Busts usually follow booms
Financial crashes do not occur randomly, but generally follow booms. Through a number of avenues, some regulatory, some not, often in the name of sophistication and modernity, the role of current market prices on behaviour has intensified.
These avenues include mark-to-market valuation of assets; regulatory approved market-based measures of risk, such as credit default swap spreads in internal credit models or price volatility in market risk models; and the increasing use of credit ratings, which tend to be correlated, directionally at least, with market prices.
In the up-phase of the economic cycle, price-based measures of asset values rise, price-based measures of risk fall and competition to grow bank profits increases. Most financial institutions spontaneously respond by (i) expanding their balance sheets to take advantage of the fixed costs of banking franchises and regulation; (ii) trying to lower the cost of funding by using short-term funding from the money markets; and (iii) increasing leverage. Those that do not do so are seen as underutilising their equity and are punished by the stock markets.
When the boom ends, asset prices fall and short-term funding to institutions with impaired and uncertain assets or high leverage dries up. Forced sales of assets drives up their measured risk and, invariably, the boom turns to bust.
My previous thoughts were here, here, and here. I am surprised that none of the proposals address the fact that increased regulation produces incentives to avoid regulations such as SIVs and SPVs that invested in subprime backed securities. The prohibition of off-balance sheet investment vehicles should be one element of the new regulatory regime. This would lead to armies of lawyers and financial engineers trying to circumvent this prohibition. Further regulation to prohibit these lawyers and financial engineers from trying to circumvent this problem should then be introduced which would then lead to ... well, you get the idea.
Part of Brad Setser's post on capital inflows mentions this:
I think we now more or less know that the strong increase in gross capital inflows and outflows after 2004 (gross inflows and outflows basically doubled from late 2004 to mid 2007) was tied to the expansion of the shadow banking system. ... It was a largely unregulated system. And it was largely offshore, at least legally. SIVs and the like were set up in London. They borrowed short-term from US banks and money market funds to buyer longer-term assets, generating a lot of cross border flows but little net financing.
My notes on CDS and CDOs are here and the use of VAR numbers to reduce aggregate risk are here. Trying to manage macroeconomic risks using individual bank VARs is essentially the same as trying to safeguard individual banks. It doesn't really work well.