Sunday, March 22, 2009

Regulation

Becker and Posner have some good ideas on what future regulation should look like. Automatic, transparent, and counter-cyclical.

From Becker:
... One major problem with regulations is the regulators themselves. They get caught up in the same bubble mentality as private investors and consumers. For this and other reasons, they fail to use the regulatory authority available to them. This implies that as much as possible, new regulations should more or less operate automatically rather than requiring discretionary decisions by regulators. ...

...I believe capital requirements should be imposed on investment banks, hedge funds, and other financial institutions in the form of maximum allowable ratios of assets to capital. One major advantage of such a requirement is that it can operate rather automatically rather than requiring regulators to make discretionary choices. The extremely high leverage in many financial institutions during the past few years created a fundamental instability in the financial sector regarding its ability to respond to large negative aggregate shocks to the system rather than only individual firm idiosyncratic shocks....

...One-way to reduce the likelihood of a too-big-to fail-problem is to impose higher capital requirements relative to assets on larger financial firms. That is, to implement a progressive set of capital requirements relative to assets that would increase as the size of a bank or other financial firm increased....

Posner:

...A natural response is to tighten up regulation. In the case of commercial banks, this would not require new legislation. (emp. added, though to make regulation more automatic as Becker proposes would require some new legislation - Joe)...

...To tighten regulation of banks at this point would thus not only be a case of closing the barn door after the horses have escaped, but also would undermine the government's policy of encouraging banks to lend...

...I would prefer to see, at least as an initial step, requiring greater regulation of specific financial instruments, in particular credit-default swaps, which are at present unregulated credit-insurance undertakings often with no backing in the form of either reserves or collateral. (This is the AIG problem - Joe) ...

...The problem of excessive borrowing can be addressed both by the Federal Reserve, which exercises a high degree of control over interest rates, and by the government's placing limits on credit-card and mortgage debt, for example by repealing the deductibility of mortgage interest from taxable income... (Not only would this be politically difficult to do, but Becker's limitations on bank leverage would go a long way towards dampening this problem. - Joe)

...But the most important point I would make is that there should be no new regulatory measures until the depression reaches bottom and recovery begins (not that there can be certainty about when that point has been reached--there were several false bottoms in the 1930s depression)...

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