Everything the IMF Wanted to Know About Financial Regulation and Wasn’t Afraid to Ask

toxic financial products

This post from Sheila Bair, chair of the U.S. Systemic Risk Council, discusses freshly and candidly financial regulation and I found it interesting. But it has some ideas of a convinced bureaucrat about the benefits of regulation that I would like to talk about.

Who would not want a financial system that was “smaller, simpler, less leveraged and more focused on meeting the credit needs of the real economy”? But how do you get all that? Is it possible to effectively reduce the size of entities? Are some smaller entities compatible with globalization and taking advantage of economies of scale? In all probability, when the European banking union is established, we will see new mergers of banking entities in the eurozone that will make them even bigger and more complex. In a similar way, the complexity of financial entities and their products is an inevitable part of the financial needs that globalization presents and the progress of financial knowledge entails. Regulation of this complexity, in addition to being difficult, may end up being counterproductive. A world that is increasingly complex needs financial instruments that are also complex and limiting financial complexity inherently restricts credit and growth.

The 2008 crisis and the following recession demonstrated that the theory of the “Great Moderation” of economic cycles turned out to be fiction and forced us to realize that societies are facing a complex choice between stability and growth. It also showed that leverage in the financial sector acts as a powerful amplifier of fluctuations in the real economy. And this forces us to rethink financial sector regulation.

I like Bair’s insistence that we must seriously face three problems:

1. The growing size of institutions
2. The systematic nature of many of these
3. The serious moral hazard that bailouts pose

Of these three problems, I would start by addressing the third. There is no doubt that if we had a simple, clear and forceful mechanism for dealing with entities that have problems, the other two problems would almost be resolved. First of all, all financial entities should be required to have a sufficiently fluffy cushion. To me, as to Bair, I like the round number of 10 percent. Then it should be clear that the intervention of any entity, no matter how large, can be carried out. And once the intervention occurs, both the owners and lenders of the entities should know without a doubt where they stand in the line of creditors.

Streets of Dublin, by William Murphy

Shareholders should completely lose the value of their investments, then junior debt after senior debt and, finally, deposits until reaching the minimum covered by guarantees. And it should be mandatory that this order be communicated in big letters and through terrifying messages when marketing financial products. For example, we could force banks to clarify that the titles of what are called preferential are in reality junior debt; which are likely to be capitalized at whatever moment the issuing entity decides and that they will lose all their value when the issuing entity has problems. Just like tobacco companies warn their clients that tobacco kills: you can go ahead and smoke if you’re not very attached to life, but later don’t complain when you have cancer and die. We can force financial entities to advise their customers about the product, which promises them a return of 10 percent and is toxic: buy it if you don´t have much attachment to your money, but later don´t complain when you go broke and lose everything.

I also like Bair’s idea of requiring entities to participate in the risk of products they sell. But in this way. Let’s let the entities sell what they want and charge corresponding commissions. But force them to put 5 percent of each emission on their balance sheets so they can participate in possible losses. With a regulation of this type, we will at the same time limit the size of entities and, therefore, their leveraging and risk taking.

Will this dream become a reality? Well, I don’t think so. But during these warm days, it’s refreshing to read, think and talk about it.


About Javier Diaz-Gimenez

Prof. Díaz-Giménez has dedicated most of his professional life to doing research and teaching macroeconomics. His recent work explores the macroeconomic consequences of fiscal policy and pension system reforms. He has published the results of his research in some of the leading professional journals such as the Journal of Political Economy and the Journal of Monetary Economics. He is also the author of the undergraduate textbook Macroeconomía: Primeros Conceptos (Macroeconomics: Primary Concepts).