More financial market regulation proposals

Interesting debate between Mark Thoma and Houman Shadab about the types and extent of regulation of financial markets. While most of the suggestions are already under circulation, the debate is worth a revisit.

Mark Thoma draws attention to Robert Lucas' concerns of systemic risk spreading from the possible regulatory arbitrage if the shadow banking system is not adequately regulated. However, Houman Shadab disagrees with the excessive concern with regulating the hedge funds and CDSs in the shadow banking system, and claims that it is more important to make "sure that regulated companies like banks do not take on excessive risks through their relationships with lightly regulated entities like hedge funds or by using instruments such as derivatives".

Mark Thoma echoes the concern raised by Andrew Lo about the possibility of large amounts of pension money flowing into hedge funds in the future, as they seek to reallocate their portfolios so as to recoup atleast some part of the massive lossess suffered by them during the meltdown. This makes it all the more important to regulate the institutions like hedge funds in the shadow banking system.

In light of the critical role played by the "too big to fail" institutions in amplifying the financial market crisis, Mark Thoma proposes putting in place measures to quantify the risks arising from the market or monopoly power or connectedness of firms. One of the suggestions is to use measures like the Herfindahl-Hirschman Index, which is a measure of the size of firms in relation to the industry and is an indicator of the amount of competition among them. Regulators can constantly monitor such indices and if they cross a threshold level, they should step in with further actions. The level of leverage is another important regulatory parameter that should be monitored.

Mark Thoma drives home the importance of system wide regulation, and the need for regulators to be one step ahead, to the extent possible, instead of being one step behind as they have been in the past. He also writes, "The level of regulation a firm or industry faces should match the size of the underlying threat. And for me, that means powerful firms need to be met with more powerful regulators — or, even better, that these firms need to have limits on how large and powerful they can become." Houman Shadab feels that it may be impossible to appropriately monitor and regulate hedge fund risks.

In light of ample evidence about excessive risk taking despite the awareness of the dangers posed, Shadab feels that "giving regulators more responsibility by broadening the kinds of companies they must look after seems to make little sense. Instead, we should be encouraging far more aggressive private risk management by the parties that got duped by Wall Street. But the more these investors rely on regulators or others to monitor risk instead of doing their own due diligence, research, and risk-management, the more complacent they’ll become. Investors tend to keep a closer eye on risk when they know they can’t rely on third parties to do the dirty work for them."

The crisis has also triggered off an intense debate about how much risk banks should bear in light of the events of recent past. Noted economists like Paul Krugman have called for ushering in an era that makes banking boring, limiting their mandate to take risks, Amar Bhide has called for an age of "primitive finance", which would mean greatly limiting what commercial banks are allowed to do, and reviving a more stringent version of the Glass Steagall Act.

Laurence Kotlikoff has called for "limited purpose banking" (and here), where commercial banks would initiate only AAA-rated mortgages and business loans (approved and rated by the government, rather than by private ratings agencies), and then bundle and sell those loans within mutual funds.

Update 1
Mark Thoma points to two regulatory mistakes that led us to this crisis - the deregulation movement of the nineties had fostered an evangelical belief that markets are self-regulating, even self-repairing; and the decreased vigilance on macroeconomic stability, arising from the economic stability of the "Great Moderation" era on eighties and nineties that gave rise to a belief that major economic crashes are a thing of the past.

Houman Shadab outlines three principles of financial sector regulation.

Update 2
Simon Johnson has come out vehemently in support of using anti-trust legislation to break up the "too big to fail" institutions so as to contain the systemic threats of such large financial institutions.

Update 3
Vox has an article summarizing methods outlined in a recent IMF paper to identify systemic risks in banking sector.

Update 4
Economix points to Ben Bernanke's vision of futire financial market regulation. He talked about the need for a new "consolidated supervision" framework in this new "macroprudential" approach to supervision:

• Monitoring large or rapidly increasing exposures — like to subprime mortgages — across firms and markets, rather than only at the level of individual firms or sectors.
• Assessing the potential systemic risks implied by evolving risk-management practices, broad-based increases in financial leverage, or changes in financial markets or products.
• Analyzing possible spillovers between financial firms or between firms and markets, like the mutual exposures of highly interconnected firms.
• Ensuring that each systemically important firm receives oversight commensurate with the risks that its failure would pose to the financial system.
• Providing a resolution mechanism to safely wind down failing, systemically important institutions.
• Ensuring that the critical financial infrastructure, including the institutions that support trading, payments, clearing, and settlement, is robust.
• Working to mitigate procyclical features of capital regulation and other rules and standards.
• And identifying possible regulatory gaps, including gaps in the protection of consumers and investors, that pose risks for the system as a whole.

Update 5
Pew report on principles of financial reforms is available here. The abstract of ICMB-CEPR report on financial reforms is here.