Tuesday, June 2, 2009

Regulating Financial Markets

Posted on Option ARMageddon by Rolfe Winkler:

The latest installment of the Financial Analysts Journal has a compelling article by Meir Statman, Professor of Finance at Santa Clara University... Among other things, he argues that leverage could be controlled by extending margin requirements to investments besides stocks, including derivatives. And why not restrict leverage in home purchases as well? 20% down-payments should be mandatory. A big criticism with this is that it would restrict “home-ownership.” But this argument is misleading: when you don’t put any money down, you don’t own anything to begin with.

Statman also recommends suitability regulations:

I would also advocate the application of suitability regulations to mortgage brokers, bankers, and other mortgage providers. Mandatory disclosure of mortgage facts, even if done in required formats that aid comprehension, is insufficient because it puts lenders and borrowers in adversarial positions….

Mortgage loans are different from credit card loans in that they are for much higher amounts and can inflict much greater damage on both borrowers and the rest of us. Suitability regulations would require that lenders not only disclose clearly all information about credit products but also guide borrowers to suitable products.

OA has long argued that lenders should be held to a fiduciary standard of care.

But the single most important regulatory overhaul needed immediately (one Statman fails to mention) is substantive capital requirements for banks. As long as we’re stuck with a fractional reserve system, the least we could do is mandate a higher fraction of reserves be kept on hand. This would have to be accompanied by restrictions on banks’ usage of off-balance sheet vehicles. No sense in reserve requirements if they can be dodged by shifting assets to the shadow-banking system…

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