Business Forum: Financial market regulation needs sanity

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People often ask if regulators and legislators have fixed the flaws in the financial system that took the world to the brink of a second Great Depression. The short answer is, no.

Yes, the chances of an immediate repeat of the acute financial meltdown of 2008 are much reduced by the fact that most investors, regulators, consumers and even politicians will remember their financial near-death experience for quite some time. As a result, it could take a while for recklessness to hit full throttle again.

But, otherwise, little has fundamentally changed. Legislation and regulation produced in the wake of the crisis have mostly served as a patch to preserve the status quo. Politicians and regulators have neither the political courage nor the intellectual conviction needed to return to a much clearer and more straightforward system.

In his recent speech to the annual, elite central-banking conference in Jackson Hole, Wyoming, the Bank of England's Andy Haldane made a forceful plea for a return to simplicity in banking regulation. Mr. Haldane rightly complained that banking regulation has evolved from a small number of very specific guidelines to mind-numbingly complicated statistical algorithms for measuring risk and capital adequacy.

Legislative complexity is growing exponentially in parallel.

In the U.S., the Glass-Steagall Act of 1933 was just 37 pages and helped to produce financial stability for the greater part of seven decades. The recent Dodd-Frank Wall Street Reform and Consumer Protection Act is 848 pages, and requires regulatory agencies to produce several hundred additional documents giving even more detailed rules. Combined, the legislation appears on track to run 30,000 pages.

The problem, at least, is simple: As finance has become more complicated, regulators have tried to keep up by adopting ever more complicated rules. It is an arms race that underfunded government agencies have no chance to win.

Even back in the 1990s, regulators would privately complain of the difficulty of retaining any staff capable of understanding the rapidly evolving derivatives market. Research assistants with one year of experience working on derivatives issues would get bid away by the private sector at salaries five times what the government could pay.

Around the same time, in the mid-1990s, academics began to publish papers suggesting that the only effective way to regulate modern banks was a form of self-regulation. Let banks design their own risk management systems, audit them to the limited extent possible and then severely punish them if they produce a loss outside agreed parameters. The ideas were implemented; it is not necessary to recount the consequences.

The clearest and most effective way to simplify regulation has been advanced in a series of important papers by lead author Anat Admati of Stanford. Her basic point is that financial firms should be forced to fund themselves in a more balanced fashion, and not to rely so heavily on debt finance.

Ms. Admati and her colleagues recommend requirements that force financial firms to generate equity funding either through retained earnings or, in the case of publicly traded firms, through stock issuance.

The status quo allows banks instead to leverage taxpayer assistance by holding razor-thin equity margins, relying on debt to a far greater extent than typical large nonfinancial firms do. Greater reliance on equity would give banks a much larger cushion to absorb losses.

The financial industry complains that efforts to force greater equity funding would curtail lending, but this is just nonsense in a general equilibrium setting. Nevertheless, governments have been very timid in advancing on this front, with the new Basel III rules taking only a baby step toward real change.

Of course, it is not easy to legislate financial reform in a stagnant global economy, for fear of impeding credit and turning a sluggish recovery into a full-blown recession. And, surely, academics are also to blame for the inertia, with many of them still defending elegant but deeply flawed models of perfect markets that create an illusion of safety for a system that is in fact highly risk-prone.

The fashionable idea of allowing banks to issue "contingent capital" (debt that becomes equity in a systemic crisis) is no more credible than the idea of committing to punish banks severely in the event of a crisis. A simpler and more transparent system would ultimately lead to more lending and greater stability, not less. It is high time to restore sanity to financial-market regulation.

bizopinion

Kenneth Rogoff, a former chief economist of the IMF, is professor of economics and public policy at Harvard University.


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