Financial Regulation To Prevent Another Financial Meltdown

Posted by Gerald Epstein on 26 February 2009

James Crotty and Gerald Epstein*

In his address to the joint session of Congress, President Obama urged Congress to develop as soon as possible new financial regulations to prevent a financial meltdown from ever happening again. The need for correcting the regulatory system becomes especially urgent as more taxpayer money is put at risk in bailing out large banks, without the government exercising the direct control over them that would come with full nationalization, which President Obama seems loathe to do. It is reckless to allow these financial institutions to continue operating in the same permissive financial regulatory environment that allowed this disaster to occur in the first place.

What, then, should this new financial regulatory regime look like?

It must, at a minimum, correct four fundamental flaws that led to the crisis: 1) Perverse incentives and conflicts of interest that lead financial actors to take on excessive risk 2) A regulatory framework that was lax at best, and virtually non-existent in the case of the "shadow banking system" of private equity firms, hedge funds and bank Special Investment Vehicles 3) Financial innovations that were opaque and vehicles for the buildup of systemic risk 4) A system that was pro-cyclical in its underlying dynamics.

We present here a nine point regulatory program designed to correct these flaws.

1. Transform financial firm incentive structures that induce excessive risk-taking.
Asymmetric and perverse incentives for top financial decision makers are ubiquitous in the present system. They receive enormous compensation in the boom that they do not have to give back in the downturn: this is a major cause of the current crisis. To reduce these incentives for excessive risk-seeking, a system of “clawbacks” through which excessive salaries and bonuses paid during the upturn would have to be repaid in the downturn. Such clawbacks could be required in compensation contracts or could be implemented via the tax system through a series of escrow funds.

2. Implement lender-of-last-resort actions with a sting.

Institutions might be too big to fail, but top firm rainmakers should not be. A key distinction must be made between the financial institution itself and the agents who made the decisions to take excessive risk and benefited from these decisions – top management, key traders and other richly rewarded operators. These rainmakers must be made to pay significantly when their firms are bailed out.

3. Extend regulatory over-sight to the “shadow banking system.”

The unregulated ‘shadow banking system’ of hedge and private equity funds and bank-created Special Investment Vehicles played a major role in the creation of the crisis. Though humbled by the current crisis, it is nonetheless still very much alive, waiting in the wings to expand again. These institutions must be brought under the strict regulatory framework that should be applied to other financial institutions.

4. Restrict or eliminate off-balance sheet vehicles.
Move all risky investments back on bank balance sheet and require adequate capital to support them. Capital requirements should be sufficient to protect bank solvency even during the liquidity crises that occur from time to time.

5. Implement a financial pre-cautionary principle.
Destructive innovations such as collateralized debt obligations (CDOs) and credit default swaps were major contributors to the development of the crisis. Once the financial regulatory structure is extended to all important financial institutions, as we propose in point 3, it would be possible to implement a regulatory precautionary principle with respect to new products and processes created by financial innovation. It would be similar in principle to the one used by the US Food and Drug Administration to determine whether new drugs should be allowed on the market. Regulators would determine whether proposed innovations were likely to increase systemic fragility. Typically, the regulatory authority would do as the Spanish authorities did when their banks asked if they could create off balance sheet CDOs with no capital requirements - tell them that as long as held as the same capital that they would have to were the CDOs were on balance sheet, they could go ahead. However, there would be cases in which the regulatory authority would prohibit the innovation on the grounds that even with more capital, it would have serious negative externalities for the system.

6. Move virtually all financial security transactions onto exchanges.

Eighty percent of all derivative products and one hundred percent of the complex CDOs, credit default swaps and other exotic financial instruments implicated in the current crisis are not traded on markets, but rather in private over-the-counter transactions. If regulators insisted that all derivative securities must be exchange traded, those OTC securities that could be simplified and commoditized would shift to exchanges where they would be transparent, involve less counter-party risk, and could provide a less expensive source of credit. The most complex products, including CDOs, cannot be sufficiently simplified and would likely disappear from the market.

7. Require due diligence by creators of complex structured financial products.
Require the financial institutions that create mortgage backed securities, CDOs and other opaque mortgage backed financial assets to perform “due diligence” on the individual securities embodied in these products as a condition for their sale. “Due diligence” would obligate the issuer to evaluate the risks of each underlying mortgage, then use this information to evaluate the risk of the asset-backed security under varying conditions that might affect the value of the underlying mortgages. This task would be difficult and costly if done properly; it could make the most complex securities unprofitable. If this could not be done to regulators' satisfaction, sale of these securities should be prohibited.

8. Restrict the growth of debt through counter-cyclical capital requirements or reserve provisioning.

A number of the previous suggestions might help restrict the excessive growth of
debt in the boom. But they may not, by themselves, be sufficient to eliminate the excessive growth of financial assets to a safe level. Financial asset creation is extremely pro-cyclical. As asset prices rise, bank capital rises as well, creating new capacity for credit creation. Banks can then increase loans until they hit regulatory capital constraints. This lending leads to a rising demand for securities and thus higher security prices, which allows the process to continue. To assure control of the rate of expansion of financial assets, regulators should impose counter-cyclical capital-asset ratios or reserve provisioning.

9. Create a bailout fund financed by Wall Street.
When the FDIC rescues failing commercial and savings banks, it uses insurance funds paid for by the banks themselves, not by the taxpayer. A similar insurance scheme should be created to finance bailouts for other kinds of financial institutions. The government should impose a small transactions tax on all security sales. The fund would typically accumulate hundreds of billion of dollars in normal and boom times prior to the outbreak of a financial downturn. If effective regulations prevent a truly dangerous risk buildup in the expansion phase of the financial cycle, the fund should have more than enough money to rescue those institutions that fail in the downturn.

Of course, for any such regulatory system to work effectively, financial regulators must have adequate personnel and resources, must be accountable, and must be serious about enforcing tough regulations. The Obama administration must signal its commitment to serious regulatory enforcement, something it has yet to do.

Over-hauling financial regulation will take some time. Meanwhile, the government should make sure these taxpayer supported banks help the U.S. economy recover and serve the public interest. After all, to paraphrase Ronald Reagan: it’s our money.

* Gerald Epstein and James Crotty are Professors of Economics and Researchers at the Political Economy Research Institute (PERI), University of Massachusetts, Amherst. This piece draws on their recent article: "Avoiding Another Meltdown" in Challenge Magazine, January-February, 2009, pp. 5 – 26.