Tuesday, June 10, 2008

Financial regulation

Megan has an excellent post asking exactly what financial regulation should be enacted given the problems the US has had with the mortgage market, commodities mortgage, credit derivative market, prime broker market, etc. She correctly identifies the key issue
If you borrow short and lend long--and all banking is some variant on this--you will at least occasionally be caught out. There's no real evidence that the problem in the housing market was supply-side, rather than demand-side, fraud. Bear Stearns wasn't taken down by its SIVs. And it's not really clear that the originators would have behaved much differently had they been keeping a piece of the loans they packaged.
Agreed. She also goes on to say, correctly, that the Motherhood and Apple Pie recommendations would not have solved the problem
Here is, as far as I can tell, a comprehensive list of all the regulations that most economists could probably agree to:

1) Increased capital requirements for investment banks
2) Cracking down on fraud in the mortgage brokerage market
3) Less off-balance sheet activity
4) Requiring originators to keep a piece of the loans they package

The problem is, it's not really very likely that these four would have prevented the current crisis.
Given that the problem is maturity mismatching, the surely the answer is to simply outlaw maturity mismatching. Such banks have existed in the past, and there are similar financial structures today, such as VC funds. If real US productivity growth comes from actual real inventions and improvements, say from tech companies, and VC funding can supply us with that, is it worth having 3.5% saving accounts at the price of systematic instability and effective nationalization of the banking sector every 8 years?

The arguments raised over whether or not investment banks should be regulated are beyond the point. The moment investment banks became "too big to fail" was the moment became (informally) part of the Government, and as such, will be directed by the Government to the extent that any one government entity can direct another.


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