Monday, May 05, 2008

Better regulation

As the US housing bubble deflates, there is an outstanding question of what different regulatory environment would have 1) kept the housing bubble from appearing, but 2) supported "good" financial innovation. Two points on this.

Firstly, the chart above shows how borrowing power increased from 3x leverage to 9x at the peak of the bubble in 06. You can see how a combination of low interest rates, lower down payments, interest only loans all played their part in fueling the boom.

Secondly, I recommend this piece on VoxEU. Key points:
1) Better disclosure does not help to prevent financial crises. They were called "subprime"!
2) Prudential controls never work either, certainly not at a system level
3) Risk management does not work, as it ignores "off model" events which end up being the problems.

Instead, he recommends:
1) Capital controls should be counter-cyclical. So as the risk premium falls, the capital charge should rise
2) Forget about "bank" vs "non-bank". Look at maturity mismatch and leverage. The more an organization has of both, the more it should be regulated. A zero leverage, maturity matched lending institution, for example, would probably need zero regulation. Hmmmm.
3) Banks should pay an insurance premium so taxpayers do not get fleeced too much when they bail banks out.
I think this last suggestion is unworkable as we've seen what a good job social security and medicare premiums have done keep future tax increases down. Any premium collected will be, instantly, spent.


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