While policymakers and policy kibitzers, among whom I count myself, debate what is needed to cure the current crisis and recession, another debate brews in the background. It is about how to fix the system so that this doesn't happen again.
Any coherent proposal for fixing the system is based on judgments about the causes of the crisis. While there are many differences in emphasis, I believe that most observers would agree on the essentials: The crisis originated with a bubble in the residential real estate market, followed by the inevitable aftermath of declining home prices, and a subsequent explosion of home mortgage defaults and foreclosures. The resulting losses were worldwide, because foreign investors held enormous amounts of U.S. mortgage-related assets. Financial institutions did not have the capital to absorb these losses, resulting in the collapse of many and the enormous infusion of capital by governments, plus loans and guarantees, to prevent the collapse of many more.
This sequence of events could be prevented by blocking the bubble, or by shoring up the capacity of the financial system to absorb the losses resulting from a bubble's collapse. In my opinion, the second option should have priority. We don't know where the next bubble will come from, but if the system has enough capital, a crisis can be averted no matter its source.
Private financial institutions will never voluntarily carry enough capital to cover the losses that would occur under a disaster scenario. For one thing, such disasters occur infrequently, and as the period since the last occurrence gets longer, the natural tendency is to disregard it -- to treat it as having a zero probability. In a study of international banking crises, finance professor Richard Herring and I called this "disaster myopia."
Disaster myopia is reinforced by "herding." Any one firm that elects to play it safe will be less profitable than its peers, making its shareholders unhappy and even opening itself to a possible takeover.
Furthermore, even if those controlling financial firms knew the probability of a severe shock, and the large losses that would result from it, it is not in their interest to hold the capital needed to meet those losses. Because they don't know when the shock will occur, playing it safe would mean reduced earnings for the firm and reduced personal income for them for what could be a very long time. Better to realize the higher income as long as possible, because if they stay within the law, the money won't be taken from them when the firm becomes insolvent.
Indeed, insolvency may not mean the demise of the firm if many firms are affected at the same time. Governments can't allow them all to fail without allowing the crisis to become a catastrophe. This is clearly borne out by the U.S. government's actions in the current crisis. Bailouts by the government further validate the premise that it is foolhardy for a financial firm to hold the capital needed to meet the losses associated with a severe shock.
This appears to lead logically to the conclusion that government ought to impose capital requirements on financial firms. Capital requirements stipulate the amount of capital firms must have, based largely on the amounts and types of assets and liabilities they have.
Unfortunately, capital requirements won't prevent financial crises. An inherent flaw in capital requirements is that required capital varies by broad asset categories, which allows the regulated firms to replace less risky assets with more risky assets within any given asset class. The shift to subprime mortgages during the last bubble, for example, did not increase their required capital.
In principle, regulators can offset this by adjusting requirements in response to changing economic conditions. For this to work, however, regulators must have better foresight than those they regulate, which they don't.
An increase in capital requirements large enough to burst a bubble would be extremely disruptive, forcing many firms to sell stock at the same time, or to substantially reduce their lending. Concerns about such disruptions reinforce disaster myopia and political timidity among regulators.
That's easy to prove. Banks and other depository institutions have been subject to capital requirements since the 1980s, but no adjustments in the requirements were made in response to the recent housing bubble.