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Regulation
Bloomberg reports that new financial regulations are on their way:
The Obama administration is preparing an overhaul of U.S. banking rules that would force financial companies to keep more cash on hand in case their trading bets go wrong.
Treasury Secretary Timothy Geithner told lawmakers yesterday that changes will include “strong oversight, including appropriate constraints on risk-taking.” Federal Reserve Chairman Ben S. Bernanke said the case of American International Group Inc. showed the “intense problem” of trading with insufficient capital to guard against losses.
This is probably good stuff, but one thing that I find persistently missing from these discussions is any sense of guiding principles. 
There are a million rules you might want to put in place to regulate the financial industry, and every one of them might individually sound sensible. But what's the big picture? What are you trying to accomplish?
If you asked me, for example, I'd toss out three big principles. #1 is firmer regulation over leverage, wherever and however it occurs. This would produce regulations like the one above that increases capital adequacy ratios, but it would also lead to similar oversight of hedge funds; an overhaul of how capital and assets are calculated; regulation of effective leverage embedded in complex derivatives; rules about off-balance-sheet vehicles; and so forth.
#2 would be a stronger commitment to act countercyclically. That would produce things like rules designed to force the Fed to keep an eye on asset inflation as well as goods inflation; a dedication to limiting credit expansion as well as credit destruction; capital adequacy rules that weren't merely stronger, but that tightened during expansions and loosened during contractions; and stronger down payment requirements for mortgage loans.
#3, for lack of a better name, is a recognition that the global financial system could stand to have a little more sand in its gears. Something to slow it down just a little bit. This might include things like a small transaction tax; exchange trading for credit derivatives; and stronger transparency rules.
Now, I might be wrong about these principles, and I might be wrong about the specific regulations needed to support them. Fine. Suggest your own. But rather than a huge hodgepodge of rules that might be good ideas on their own but might not really work together to accomplish what you want, I'd like to see a moderate, well-targeted set of rules aimed at fixing two or three big things. The principles should guide what we do, not the other way around.
First, exorcise Phil Gramm
Agree on Kevin's principles. How about three tactical changes:
1. Reinstate the Glass-Steagall Act in its final form (prior to repeal)
2. Repeal the Gramm-Leach-Bliley Act
3. Repeal Commodity Futures Modernization Act of 2000, which enabled unregulated market in credit default swaps, among other things
More reform
4. Firewalls between financial businesses.
Agree with Devildog above. I would argue that bringing back Glass-Steagall is more than tactical, it is fundamental. Firewalls between different financial businesses are essential, taking them away has proved to have been a disaster. No more financial holding cos.
5. Better incentives for credit agencies and auditors
Credit rating agencies also deserve a lot of the blame for the current mess,. they should be held accountable for their judgements. The auditing system is also in need of repair, even after the post-Enron reforms. Too much conflict of interest when examing the books of a client. Perhaps assign qualifed auditors by rotating lottery. Maybe pay them through third-party organization.
6. Control of Cross-border Capital Flows
Cross border capital flows are a huge problem and were at the root of the Asian currency crisis and the U.S. housing bubble. International regulatory arbitrage is also a problem. The big financial players also exploited looser regs in a place like London. I don't know how you solve this. Everyone knows it's a problem but no one wants to shut down international finance.
Overall Level of Credit
I agree with your points, Kevin, and even moreso with the desirability of having some guiding principles.
Financial and monetary principles, in turn, need to be part of a bigger package of economic principles. For example:
These are just some examples off the top of my head...
Transparency
I would add the principle of making financial transactions as transparent as possible. I suspect that things would not have gotten so bad if financial manipulators had not been able to hide their shenanigans.
A transaction tax?
tagged as:- solution
In my dreams! Transaction taxes have been floating around the edges of the possible for a while, but I don't see where the political oomph to get it done would come from. As a favor to a long-time reader, could you expand on what it would take in a later post, Mr. Drum?
Four possibilities
Though I know little, I'd posit 3 principles:
1) Systemic risk tax (taxation of big companies making big bets, taxation of leverage, taxation of profits on asset classes growing much faster than previous experience);
2) Reform the incentives of financial decisionmakers (require some bonuses to be paid in restricted stock that can only be liquidated in say 10 years, change incentives of rating agencies)
3) Transparency regulations (a financial institution's precise risk exposure and stress test performance should be public knowledge)
4) Possibly, prediction markets for asset price bubbles [the private sector might take care of this one]
Uh, 4.
Uh, 4.
One more suggestion
Hi,
How about adding this one?
"The Captain goes down with the ship."
Have a nice day,
Antti
g.powell beat me to the punch
on changing incentives for auditors and ratings agencies. But in addition I think we need to see some incentive changes within all major financial players. The drive for short term results to pump up bonuses and stock options is a huge problem.
I imagine this will be a difficult regulation do design and enforce, but we have to address it. Perhaps bonuses above some threshold can only be given out in stock options that vest over a long time horizon, like 10 years from inception. Or explicit clawback provisions based on company losses due to a executives past decisions and actions.
I think perverse incentives, or the idea that most people are out to benefit their company and not themselves individually, are the most basic over-arching issue and should be the "big picture" that drives the regulation. Greenspan said thought company executives were best equipped to protect shareholder value and was genuinely surprised at their massive failure to do so. But I think he still doesn't understand or won't admit that it wasn't a lack of capacity to protect shareholders that cause the problems, it was lack of desire. These CEO's and hedge fund managers knew what was going on but were making 10's of millions because of it. The governor of Lebabnon's Central Bank year ago prohibited bank purchases of MBS's and he makes about 200k per year, gets no bonuses, and has been there over a decade so he's not looking to jump into a multimillion dollar job at private company. I don't think he's the smartest guy in the world, he just wasn't getting paid to lie.
Principles
Principles are sometimes a bit more broad than 'limiting leverage'.
Fewer ways to benefit from tearing things down.
Greater profits from longer-term investment strategies.
No betting, limited speculation and mostly investing.
More transparency -- no off-shore off-the-books hide & seek lies.
More balance of risk and safety -- not fake hedging or over-leveraging or fake ratings.
More accountability -- no golden parachutes for going bankrupt.
Tax on transactions is silly
And merely regressive on small investors. "Slowing" finance down solves fuck all as to the origins of the crisis; why you think rendering things more inefficient and thus more expensive is a gain (an in a manner that would penalise the 'little guys') escapes me - (but then so did your 'progressive' desire to give the little guys a chance at losing their shirts in high risk debt bets).
More transparency on systematic connections, unified regulation to knit together oversight better, that makes sense.
Your leverage obsession is vaguely amusingly Quixotic and naive, but improved rules about off-balance sheet exposures is in fact not only doable, but actually useful.
> "The Captain goes down
> "The Captain goes down with the ship."
> Have a nice day,
>Antti
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