KRF: It is not obvious that financial regulations were weakened during the last few years. This claim seems to have been the product of a Presidential election in which both candidates were running against the incumbent. In fact, one could easily point to important new laws and regulations such as Sarbanes-Oxley to argue that market regulation increased. As more tangible evidence, the SEC's budget increased from $377 million in 2000 to $906 million in 2008. It is certainly true that different regulations could have reduced the magnitude of the current turmoil, but that is like saying a different portfolio allocation could have produced higher returns.
The challenge is to develop regulations that will reduce the probability and cost of future problems without imposing unnecessary burdens on the economy. Although we have to resist the temptation to fight the last war, the current turmoil and the ongoing bailout do teach us a lot about how we can improve financial regulation. First, we should improve the resolution mechanism for financial firms. Counterparty risk is a primary concern in financial transactions. As a result, bankruptcy is essentially a death sentence for banks and other financial institutions. It is almost impossible, for example, for an investment bank to file for bankruptcy, reorganize, and emerge as a viable business. The process the FDIC uses to take over failed banks seems to be a good foundation for developing a more general resolution mechanism.
Second, we should improve the capital requirements and other regulations that limit the default risk of financial firms. The ongoing bailout of Wall Street is probably not a one-time event. Even with an improved resolution mechanism, it is easy to imagine that under similar circumstances we will bail out the banks again. If so, they have a strong incentive to take more risk. When things work out their shareholders keep the profits and when they don't taxpayers cover the losses. As we saw with Freddie Mac and Fannie Mae, this is not a good business model for taxpayers. If we are going to insure financial firms, we need regulations that will limit the risk they take.
EFF: Before the turmoil, most financial innovations (mortgage backed securities, credit default swaps, collateralized debt obligations, etc.) seemed like good ideas. After the fact, some turned out poorly. Could regulation have prevented the bad outcomes? Perhaps, if regulation were ideal, but probably at the expense of stifling financial innovation.
If the norm is that the Government (taxpayers) bails out the financial sector when things go wrong, and financial firms go along with the bailouts, then more regulation is in order. The prospect of bailouts if things go bad allows managers to take more risk, and this "moral hazard" problem requires regulation of risk taking. Legislators and regulators will have to decide which institutions are the likely recipients of bailouts, and then regulate their risk taking. Sounds simple, but the devil is in the details.
The ideal legal and regulatory system would be ground rules that allow bad financial innovations to fail and work themselves out of the system without government intervention. Again, the devil is in the details.
More generally, current events are certain to produce more regulation, and much of it is likely to be counterproductive. My longtime colleague, George Stigler, was famous for his argument, buttressed by empirical evidence, that regulators are eventually captured by the regulated. As a result, regulation often has results opposite those intended.
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