Financial RegulationPaths Taken and Paths Forward

Ivan J KirovFed Challenge

Feb 4 2010

Capital• Savers• Investment vehicles

Financial Intermediation

• Banks• Financial Markets

Investment• Firms• Entrepreneurs

The Financial System Financial Institutions

Solve informational asymmetry Leverage economies of scale

Bank “Self-Regulation”◦ At sign of trouble:

Creditors pull out Depositors withdraw Difficult to raise money in capital markets

Hence capital kept on hand

Banks are Businesses, Too

Discipline

Depositors

Creditors

Money Markets

Finance is systemically important to the functioning of the economy

…Then again, maybe not

Real Econom

yTransmissio

nBanks

Financial Distress

- I- Y

- ΔY

Credit tightens Less Profitability and Growth

Liquidity (Lender of last resort)◦ Traditional purview of central banks

Deposit insurance◦ In US, from Depression

Creditor guarantees◦ Mostly from last crisis◦ AIG◦ Citi

Government Intervenes

Guarantees reduce risk in holding bank debt Moreover, they insulate creditors from loss

◦ Risk-taking proliferates Financial institutions’ incentives become out

of line with those of regulators

Moral Hazard

Source: Economist

Banks’ Equity as % of Assets

To avoid moral hazard implicit in support, governments impose financial regulatory structures

Animal Spirits Contained

Capital• Structural

security• Asset buffer

Liquidity• Rapid-

response• Psychological

buffer

Pay• Align

incentives• “Micro”

buffer

Accounting• Trans-border

coordination• Transparency

Basel-2: Current main international regulatory framework

Financial institutions must keep on hand at least 4% of risk-weighted assets◦ “On hand”: Tier-1 capital◦ “Risk-weighted”: According to GAAP, but in

practice a firm-specific definition

Problems◦ Tier-1 capital includes debt-like instruments◦ Low capital margin◦ Limited regulation of leverage

Basel-2

Tobin Tax

Britain’s Bonus Tax

Obama’s Bank Levy

The Volcker Rule

Basel-3

New Regulatory Proposals

Originated by James Tobin in 1973 FX transactions above “optimal level” – tax

to bring them in line with public optimum.

Financial Tobin Tax is not strictly a form of regulation; more like enforced downsizing.

Problems:◦ How do governments know finance’s “optimal

size”?

Tobin Tax

Dec. 10, 2009: UK gov’t imposes 50% tax rate on bank bonuses exceeding £25,000

Largely politically motivated

Britain’s Bonus Tax

29%

40%

21%

10%

26-Jan-10

LabourConservativeLib-DemOther

Tax on financial firms with >$50 billion in assets

Would raise $90bn over 10 years To cover TARP fund Applies mostly to risky activities

◦ Proprietary trading desks

In practice: small, symbolic Principle?

Obama’s Bank Levy

Source: New York Times

Semi-reinstatement of Glass-Steagall

Banks (or just deposit-taking institutions?) cannot engage in proprietary trading or invest in hedge funds or PE funds

Details still pending Congressional crucible

Volcker Rule

Institution Estimated Revenue Loss

Goldman Sachs $4.5 bnJPMorgan $2 bnCitigroup ~ $500 milSource: New York Times

Work-in-progress: refinement of Basel-2 rules

General thrust◦ Safe “Tier 1” capital more narrowly defined (mostly

only equity)◦ Financial institutions cannot use proprietary risk

models◦ Liquidity: banks must withstand 30-day credit freeze◦ Capital requirements increased to 6-8% of risk-

adjusted assets

Basel-3

Liquidity regulation

Institutions pay for not-so-implicit guarantees

“Convertible capital”

Balance between institution-specific and system-wide regulation

Paths forward?

Julian Simon: The Dismal Science?

“One can hardly imagine, I think, how poor we would be today were it not

for the rapid population growth of the past to which we owe the enormous

number of technological advances enjoyed today. . . . If I could re-do the

history of the world, halving population size each year from the beginning

of time on some random basis, I would not do it for fear of losing Mozart

in the process.”

-Edmund S. Phelps

A Little Fun