Effective Regulation - Part 1: Avoiding Another Meltdown

The first installment of our series on effective regulation

Fix the system, not just today’s problems

This is the first in a series of papers addressing the topic of financial regulation. We analyze the build-up of global economic imbalances; how these imbalances led to housing bubbles in many countries; and how poorly managed risk related to securitization, along with inconsistencies in the regulations that applied to different financial activities, helped to transform these imbalances into a global financial crisis.

A “global savings glut” fed the housing bubble

Imbalances in the real economy in recent years forced the global financial system to absorb enormous excess liquidity. The problem was not the savings themselves, but the magnitude and speed of their accumulation. The resulting “global savings glut” overwhelmed domestic investment opportunities in emerging markets and instead flowed into developed-country asset markets, especially housing markets.

Systemic firebreaks failed

Securitization – which historically had been useful in reducing risk at the firm level and the regional level – ultimately increased risk at the system-wide level. It reduced the effectiveness of systemic “firebreaks” by spreading what had traditionally been very local risks; this increased correlations across asset classes and regions. At the same time, the regulatory treatment of securitized loans reduced system-wide capital levels, impeding the financial system’s ability to manage large shocks. Further damage was caused by the spread of complex financial holding companies. Because different arms of these entities were subject to different accounting rules and regulatory oversight, firms could exploit those differences to drive near-term profits higher while building and warehousing risks that only became apparent later.

Looking ahead

We offer four principles for rebuilding the global financial system: (1) Capital gluts must be managed, and asset bubbles cannot simply be allowed to run their course. (2) Securitized loans should, in aggregate, face the same capital requirements as the underlying loans would if they were held on bank balance sheets. Securitization would then be driven by a desire to reduce hazardous concentrations of risk, rather than a desire for capital relief. (3) Lending institutions should be required to mark large loans to market at origination, forcing symmetry across the recognition of profit and risk. (4) Lending linked to investment banking activities should be consolidated into the investment banking arm and subjected to full mark-to-market discipline and all regulatory and accounting rules that apply to trading assets. This would eliminate the ability to exploit differences in regulation or accounting. Further, financial institutions involved in investment banking should be required to have an independent, appropriately staffed and fully-resourced control group to mark and manage the resulting risks.

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