Friday, September 25, 2009

Regulating Systemic Risk

Posted on the Baseline Scenario by James Kwak:

David Moss wrote a good article in Harvard Magazine about systemic risk and regulation; it’s based on an earlier working paper of his. The problem statement is not particularly original, but very clearly put: Depression-era regulation brought an end to recurring financial crises because deposit insurance was combined with strict prudential regulation to guard against moral hazard. Half a century of stability, however, was undermined by a philosophy that regulation was not only unnecessary but harmful in financial markets, at precisely the same time that financial institutions were becoming dramatically larger in proportion to the economy as a whole. For example, as Moss points out, “the assets of the nation’s security brokers and dealers increased from $45 billion (1.6 percent of gross domestic product) in 1980 to $262 billion (4.5 percent of GDP) in 1990 to more than $3 trillion (22 percent of GDP) in 2007.”

The problem today, in Moss’s words, is that “implicit guarantees are particularly dangerous because they are typically open-ended, not always tightly linked to careful risk monitoring (regulation), and almost impossible to eliminate once in place.” The solutions he outlines basically boil down to renewing that tradeoff, so that government guarantees are explicit and financial institutions pay for them through more stringent regulation and cash.

On stricter prudential regulation:

“[A]n important advantage of the proposed system is that it would provide financial institutions with a strong incentive to avoid becoming systemically significant. This is exactly the opposite of the existing situation, where financial institutions have a strong incentive to become ‘too big to fail,’ precisely in order to exploit a free implicit guarantee from the federal government.”

On making systemically important institutions pay for their guarantees:

“One option for doing this would be to create an explicit system of federal capital insurance for systemically significant financial institutions. Under such a program, covered institutions would be required to pay regular and appropriate premiums for the coverage; the program would pay out ‘claims’ only in the context of a systemic financial event (determined perhaps by a presidential declaration); and payouts would be limited to pre-specified amounts.”

Moss thinks there needs also needs to be a receivership process in place as a backstop should both prudential regulation and capital insurance fail.

I think this all makes sense in concept, although I still prefer the idea of simply breaking up the large financial institutions and preventing them from reassembling, either through size caps (yes, I know, this is a complicated issue) or new antitrust laws. One problem I see is that better regulation is based on the premise of better regulators, and until that problem is solved (pay them more? inspect them more closely?) nothing else follows. Moss favors a new agency dedicated to systemic risk regulation (read: not the Fed). However, I previously referred to this as the “posit a good regulatory agency” premise. I prefer the idea of just having smaller financial institutions because it doesn’t require this particular can opener.

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