Monday, April 19, 2010

Some interim thoughts on financial regulation

They come up once in a while and I've resisted the temptation to put every frivolous thought I have down but the recent post by Krugman was just too hard to resist. Krugman's post is excellent in that it has distilled the relevant points into an easy to read format.

1. Leverage needs to be regulated and I concur that it will be hard to monitor how well it is being enforced. Likewise, limits to or banning proprietary trading would also help.
2. Bringing the shadow banking sector in to the formal sector and subjecting it to the same regulations would also help but what will be done to prevent finance from squeezing out into some other sector (or geographical area)?
3. Counter cyclical capital requirements
4. New financial products should not be introduced at a "large scale" until centralized exchanges with transparent prices are developed. I did not realize until I started reading some books on the fall of Bear Stearns that marking to market meant that the trader of an investment bank called up a few of his counterparts on Wall Street and asked how much they would accept for such-and-such as collateral.

After this crisis I think that there is a desire to return to what Krugman refers to as the Quiet Period when banks were heavily regulated and there was little competition:

... an important part of the story was the simple fact that banking wasn’t very competitive: with limits on the interest banks could pay, coupled with barriers to entry, banks had a large franchise value – and this made bankers reluctant to take risks ... no policymaker can explicitly call for restoring that aspect of the financial world: let’s make the banks fat, happy, and sleepy is not a slogan anyone wants to run on.

I am pessimistic that there is any kind of financial reform that will will return us to that quiet period, short of regulating financial institutions as though they were utility companies. In which case, we will see some form of financial crisis every few years which Jamie Dimon said and was pilloried for saying it.

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