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Regulating the US Financial System to Avoid Another Meltdown

There is broad agreement that lax financial regulation, especially in the United States and United Kingdom, contributed in a big way to the current global financial mess. In recent months, there have been widespread calls for a regulatory overhaul of financial markets regulation. But there is little agreement on what those specific changes should be. If the power and influence of private finance is not reined in, we will return to the destructive deregulation/bailout dynamic that has characterised the last several decades. This paper lays out a nine-point plan for regulatory reform, specifically tailored to address the structural flaws in the us financial system.


Regulating the US Financial System to Avoid Another Meltdown

James Crotty, Gerald Epstein

There is broad agreement that lax financial regulation, especially in the United States and United Kingdom, contributed in a big way to the current global financial mess. In recent months, there have been widespread calls for a regulatory overhaul of financial markets regulation. But there is little agreement on what those specific changes should be. If the power and influence of private finance is not reined in, we will return to the destructive deregulation/bailout dynamic that has characterised the last several decades. This paper lays out a nine-point plan for regulatory reform, specifically tailored to address the structural flaws in the US financial system.

This paper draws liberally from James Crotty, “Structural Causes of the Global Financial Crisis: A Critical Assessment of the ‘New Financial Architecture’”, 2008, PERI Working Paper, http://www.peri.umass.edu and James Crotty and Gerald Epstein, “Avoiding Another Meltdown”, Challenge, January/February 2009, Vol 52, No 1, 5-26.

James Crotty (crotty@econs.umass.edu) and Gerald Epstein (gepstein@ econs.umass.edu) are at the Department of Economics and Political Economy Research Institute, University of Massachusetts, Amherst.

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1 Introduction

wo years in, the global financial crisis that started in the US subprime sector and broader financial markets is deepening and spreading throughout the world, turning now into a full-blown global economic crisis. While the intense focus of governments has mostly been on dealing with the short-run fall-out of the worsening crisis, policymakers, economists and the general public are also beginning to turn their attention to financial regulation in an attempt to figure out what went wrong and how to prevent such a crisis from occurring again. Pressure from the public for answers and reform is becoming especially intense, as taxpayer anger in the US and elsewhere over multibillion dollar bank “bailouts approach the boiling point”.1

For now, there is broad agreement that lax or “light touch” financial regulation, especially in the US and UK, was a major contributor if not primary cause of the current mess. In recent months, a number of economists, policymakers, international financial institutions and commissions have issued reports on the need for new financial regulation and, in many cases, specific proposals for change (see, for example: Stiglitz 2009; Soros 2008; Group of 30 2009; GAO 2009; Brunnermeier et al 2009; Stern School, NYU 2008).2 Politicians too – from President Barack Obama to Nicholas Sarkozy of France – are calling for a regulatory overhaul of financial markets regulation.

But there is little agreement on what those specific changes should be. More to the point, it is unclear what stomach governments will have to take on powerful interests that historically have been very successful in pushing for financial deregulation, and which, though battered and bruised, are still a formidable force.

Indeed, a look at the proposals coming from many economists and political figures do not offer great hope that the lessons of the current crisis are truly being learned or that the past practices where the power and influence of private finance, now weaker but not tamed, dominate the financial policy agenda will be overturned. If, however, these forces are not defeated, then at best, we will return to the destructive deregulation/bailout dynamic that has characterised the last several decades: a cycle of deregulation, financial expansion, economic crash, government bailout, more financial deregulation and financial expansion. And, at worst, without major financial re-regulation that significantly reigns in the “animal spirits” of financiers, we are destined to ride this calamitous collapse further downwards.

In a companion piece, James Crotty details the structural flaws in the lightly regulated financial system – the so-called New Financial Architecture (NFA) – that led to this crisis. Here we lay


out a nine-point plan for regulatory reform, a plan that is tailored to addressing these structural flaws. And while this programme is directed to the situation in the US, we believe that it has, perhaps in modified form, many elements that are appropriate to other countries, even to global reform of financial regulation. Of course the challenges facing the government go beyond re-regulating the financial system itself (see Progressive Economist’s Statement www.peri.umass.edu). In just the financial sphere, the government faces the daunting challenge of downsizing the financial sector which got extremely bloated over the last several decades while at the same time preventing a total collapse. It must also contribute to rebuilding a new financial system, one that serves the needs of people, rather than only the rain-makers and top executives.

Before developing our programme, we first discuss the sorry state of the traditional debate on financial reform, underlining the urgency of taking a more radical approach, one that really addresses the flaws that have got us to this point.

Current Proposals for Financial Reform

Many current proposals for financial sector reform have an Alice in Wonderland quality to them. Take for example A Hundred Small Steps, the report on Indian financial reform prepared for the Planning Commission by a committee headed by Raghuram G Rajan, a professor of economics in the University of Chicago Business School (Planning Commission 2009). This document, written as the global financial system was becoming unglued and published in 2009 when the collapse had become abundantly clear, calls for significantly more financial liberalisation in India. It frames this proposal by appealing to neoclassical economists’ idealised views of financial markets, views that have now been shown to be patently false. This call comes despite the fact the India’s relatively strict financial regulations and widespread public ownership of banks has almost certainly protected the country from the first-round effects of the financial meltdown (Reddy 2008).

A Hundred Small Steps asks: “Are Financial Markets Casinos?”. It answers emphatically in the negative: “It is true that a number of investors are risk-seekers…but unlike gambling, which is based purely on luck, the investor in financial markets has a view of future outcomes and it is this that allows prices to be informative because the price aggregates collective information. And informative prices affect real decisions and thus help the economy, unlike pure gambling, which only involves transfers from losers to winners…” (105).

Yet, even the major investment bankers that were making these bets, now take a more realistic view of how informative financial prices can be. Writing in August 2008, representatives of the biggest Wall Street firms note: “…it is clear that credit risk had been mispriced for some time…the extraordinary tightness of credit spreads…was widely seen as unsustainable…however… many, if not most market participants (concluded) that when the correction took place it would be gradual and orderly. Obviously, that conclusion was wrong” (CPMG, III 2008).3

The Planning Commission report goes on to say, “Flexible financial prices are a shock absorber” (106). This was written in a world that had just seen a huge bubble in home prices in the US, the UK and elsewhere. This bubble was associated with a Minskystyle creation of a complex structure of financial assets and debts organised around these high financial prices; and then, as the prices collapsed, they dragged down this whole superstructure of debt and finance along with them. It is clear, therefore, that these “flexible financial prices” have been shock creators, not shock absorbers. For example, the housing price collapse in the US was a shock that would have been painful under any circumstance. But the vast interconnected web of opaque securities built around the housing bubble and lodged in banks and portfolios around the globe accelerated the price declines, as well created many further real and financial shock waves through the system.

Praising the use of complex derivatives, the report states: “… sophisticated derivative markets…are as much a technological input into a road project as are…state-of-the-art construction equipment…” (106). Yet, as we now know, many of these complex derivatives, including collateralised debt obligations (CDOs) and credit default swaps (CDS) are at the heart of the financial meltdown. Take, for example, CDOs of asset backed securities (so-called CDOs of ABSs). According to analyses recently reported in the Financial Times, almost half these credit products that (were) ever built out of other securitised bonds have now defaulted, and of those issues in the last few years of the credit boom, almost two-thirds are in default (Paul J Davies, “Half of All CDOs of ABS Failed”, Financial Times, 11 February 2009, http:// www.ft.com/cms/s/0/ddaa47f4-f79b-11dd-a284-000077b07658. html). According to the daily, “These defaults have affected more than $300bn worth of collateralised debt obligations which were built out of bits of other asset backed securities such as mortgage bonds, other CDOs, structured bonds, or derivatives based on these.” These have caused huge losses to major banks and have been one of the key factors driving these banks toward insolvency. Now, of course, these banks cannot finance road building or anything else.

It is also increasingly recognised that another “financial innovation”, “credit default swaps”, which were unregulated over-thecounter “insurance instruments” that were turned into complex means by which banks and others could gamble on financial failure, have enormously complicated the winding down of debt positions. The existence of these swaps are likely to be a key reason for why the crisis is so difficult to resolve and have cost the US taxpayers billions of dollars, including the $150 billion spent to effectively nationalise AIG insurance company (see for example, Newsweek 2008 and Whalen 2009).

Not unaware of this history, The Planning Commission report does caution that “derivatives are like dynamite – used properly in construction they can move mountains; used improperly, they cause tremendous damage. The point then is to create all the conditions that will make markets work well…” (107).

Yet what do they propose to protect us from this dynamite, but “light touch”, “principles-based” regulatory systems based primarily on self-regulation by financial firms – precisely the regulatory system that has got us into this mess in the first place. This call for light touch regulation echoes the report of the (ex) top US investment banks in August 2008, who, after a long

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report detailing problems that led to financial calamity, manage to state: “...supervisory practice and policy as applied to large integrated financial intermediaries constitute a sizeable challenge for the international community of prudential supervisors. On the whole, however, the supervisory process works reasonably well, especially as the emphasis of supervisory practices has shifted, in recent years, toward a principles-based approach” (CMCPG, III, 137).

In September 2008, chairman Rajan was praising his report in the IMF’s Finance and Development, just as Lehman Brothers was collapsing (Prasad and Rajan 2008). At the same time, Christopher Cox, Chairman of the US Securities and Exchange Commission, which was in charge of the principles-based/voluntary regulation of the investment banks, including Lehman Brothers that had just failed, had a much more clear-eyed view of self-regulation based on “principles-based” regulation. Said Cox, “The last six months have made it abundantly clear that voluntary regulation does not work” (http://www.sec.gov/news/press/2008/2008-230.htm)

Now, many other economists have come out with plans for financial reform and regulation (see for example, www.voxeu.org for a sample). But even while other reviews and reports take a somewhat less sanguine view than does the Planning Commission report of the power of price discovery in lightly regulated, complex financial markets, their proposed regulations, for the most part, are not up to the task at hand (for example, Group of 30 2009; NYU Stern Report 2008; Brunnermeir et al 2008; Dewatripont et al 2009). A recent review of these mainstream reform reports by New York University’s Thomas Phillipon on VoxEU notes that: “The various reports agree broadly on the ‘principles’ that regulations should follow, and in particular that they should be based on rules rather than discretion and should address well-identified externalities. When it comes to concrete proposals, however, there are fewer practical ideas and less agreement” (http://www.voxeu.org/index.php?q=node/3076).

In fact, for dealing with systematic risk, many of the proposals call for more complicated value at risk modelling, but not for firmer oversight and regulation; they do not agree on whether hedge funds and private equity funds should come under stricter regulation, or what type of regulations so-called “large and complex financial institutions” should be subjected to. Though there is agreement on the need to reduce the procyclicality of the financial system, there is no agreement on how to do it.

Indeed, some of the recent proposals, issued with great fanfare by a star-studded crowd of economists, continue to favour “light” touch regulation, despite all that has happened (see Brunnermeier et al 2009).

There are some important exceptions: some sets of proposals that have been written or are in the process of being developed, are taking quite seriously the fundamental changes that need to be made in our regulatory system. These include the proposals being developed by the Presidential Commission on Reforming the Financial System at the United Nations, headed by Joseph E Stiglitz (http://www.un.org/ga/president/63/commission/members.shtml) as well as proposals developed by the Trade Union Advisory Committee to the OECD (TUAC). George Soros has also

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made some important contributions to the regulatory debate (www.georgesoros.com).

All of them call for significant strengthening of rule-based regulation, regulation that will significantly curtail the destructive tendencies of financial markets.

Nine-Point Programme for Financial Regulation

As James Crotty’s companion piece elaborates, there were a number of fatal flaws in the lightly regulated financial system that led to these crisis which can be combined into four key problems: (1) asymmetric and perverse incentives 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”, (3) financial innovations and structures that were murky and opaque, (4) a system that was at root pro-cyclical in its underlying dynamics.

In what follows, we arrange this nine-point plan according to how they can correct these four basic flaws. As will be obvious, the proposals are complementary, but inevitably have some overlap and will likely be relevant to more than one problem. But, in our view, this is not a weakness. Regulatory back-up and overlap is in fact desirable in a system where attempts to evade regulations will be endemic and where fundamental uncertainty is pervasive.

2 Reduce Asymmetric Incentive Structures and Moral Hazard

The NFA has widespread perverse incentives that create excessive risk, exacerbate booms and generate crises. The current financial system is riddled with perverse incentives that induce key personnel in virtually all important financial institutions – including commercial and investment banks, hedge and private equity funds, insurance companies and mutual and pension funds – to take excessive risk when financial markets are buoyant.4 Here are a few of many, many examples. The growth of securitisation generated fee income throughout the system. Since these fees do not have to be returned if the securities later suffer large losses, everyone involved had strong incentives to maximise the flow of loans through the system – whether or not they were sound. Top investment bank traders and executives receive giant bonuses in years in which risk-taking behaviour generates high revenue and profits. Of course, profits and bonuses are maximised in the boom by maximising leverage, which in turn maximises risk. Credit rating agencies that play a crucial role in the NFA were also infected by perverse incentives. Under Basel I rules, banks were required to hold 8% of core or tier one capital against their total risk-weighted assets. Since ratings agencies determined the risk weights on many assets, they strongly influenced bank capital requirements. High ratings mean less required capital. They therefore facilitate higher leverage, higher profit and higher bonuses, but create higher risk as well. Moreover, important financial institutions are not permitted to hold assets with less than an AAA rating from one of the major rating companies. There is thus a strong demand for high ratings. Ratings agencies are paid by the investment banks whose products they rate.


2.1 Transform Financial Firm Incentive Structures that Induce Excessive Risk-Taking

Without solving this key problem of asymmetric and perverse incentives, it might not be possible to create an effective regulatory regime. The reason that bankers take excessive risk in the boom is they do not have to give the bonuses back when their actions crash the firm. Indeed, the high paid deal makers continue to get surprisingly large bonuses. Thus, they win big in the boom and win small in the crash. Meanwhile, the government always tries to keep the crash in check. Regulation must create time consistency: the bankers get the bonus ex post, when it is clear that the gains are permanent. One mechanism to make the payoff structure more symmetrical, and thus reduce incentives for risk-seeking, would be to implement “clawbacks” through which excessive salaries and bonuses paid during the upturn would have to be repaid in the downturn.5 Such clawbacks could be required in compensation contracts or could be implemented via the tax system, through a series of escrow funds and limitations on deductions from losses. Of course, there would be great incentives to engage in tax or restriction avoidance as is always the case. The appropriate response is not to stop trying to use appropriate taxes, but to enforce the tax laws more vigorously. Incentives to ratings agencies also need to change. If they were paid by institutional investors or associations of security buyers rather than the investment banks who sell complex products, the incentive to give excessively optimistic ratings would be eliminated. Alternatively, the government could create independent public ratings agencies that might function in a manner similar to the Government Accountability Office.

2.2 Implement Lender-of-Last-Resort Actions with a Sting

Institutions might be too big to fail, but no chief executive officer (CEO) should be. The CEOs of the seven largest investment banks received a total of $3.6 billion from 2004-07, yet the market capitalisation of their firms declined by $364 billion from their peak values, an average fall of 49%. As long as there is financial capitalism, there will be a need for some lender of last resort bailouts, even if all of these proposed policies are implemented. But a key distinction must be made between the financial institution itself and the agents who made the decisions to take risks and benefited from them – top management, key traders and other richly rewarded operators. These rainmakers must be made to pay significantly when their firms are bailed out. As things currently stand, the perverse incentives embodied in financial firms’ asymmetric reward structure are underwritten by the central bank, which creates extreme moral hazard.

3 Broaden and Strengthen Regulatory Reach
3.1 Extend Regulatory Over-Sight to the ‘Shadow Banking System’

The “shadow banking system” of hedge and private equity funds and bank-created SIVs had become increasingly powerful. Though humbled by the current crisis, it is nonetheless still very much alive, waiting in the wings to revive if and when the crisis is over. This “shadow banking system” played a key role in creating

90 the conditions that led to the global crisis. These institutions must be brought under adequate regulatory control. Investment banks also played a crucial role in the NFA and bear substantial responsibility for creating the current crisis. Though the Federal Reserve does not regulate them, it was forced to bail them out. Dangerous risk-taking caused the big five independent investment banks to disappear in the crisis; two went bankrupt, one was taken over by a commercial bank, and two converted themselves from investment banks to financial conglomerates. The SEC was responsible for regulating investment banks, but it required only voluntary compliance with its rules and never even read the compliance reports submitted by the banks – yet another example of “phantom” regulation. Investment banks need to be tightly regulated.

3.2 Restrict or Eliminate Off-Balance Sheet Vehicles

Move all risky investments back on bank balance sheets 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. As an illustration of the potential effectiveness of this proposal, consider that several years ago a group of Spanish banks approached the Spanish central bank asking permission to set up a network of SIVs that would allow them to profit from off-balance sheet holdings of mortgage-backed CDOs without setting aside capital to support them. The Spanish Central Bank demanded that these banks post an 8% capital charge against SIV assets, just as they would have to do if they were on the balance sheet. This stopped the innovation in its tracks (“Spain’s Banks Weather Crisis”, Financial Times, 31 January 2008). The Economist observed that “with no reason to set up the SIVs, the Spanish banks did not bother. Other countries could have saved themselves a lot of trouble by taking a similarly rigorous view of consolidation” (“Spanish Steps”, 17 May 2008). This sensible decision did not prevent Spain from enduring a housing-related financial crisis, but it did eliminate one key element of the meltdown in the US and elsewhere (“Time for Central Bankers to Take Spanish Lessons”, Financial Times, 30 September 2008). Spain, to be sure, did endure a huge real estate boom and crash. But it was the “old fashioned” kind, where banks lent developers and home buyers a great deal of money, creating a bubble. But, it was not fuelled by exotic derivatives, so, Spanish banks were not vulnerable in the way US banks were.

3.3 Implement a Financial Precautionary Principle

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 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. Destructive innovations were at the centre of crisis-creation. Spanish banks had to ask permission from the Bank of Spain to create off-balance sheet SIVs. This principle could be extended to all financial institutions and all important proposed financial innovations. Regulators would determine

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whether these innovations are likely to increase systemic fragility. Typically, the regulatory authority would do as the Spanish authorities did: tell the financial institution that as long as it can raise sufficient capital to insure that the risk to that institution is minimal, it can implement it. Regulators would be empowered to monitor the evolution of the innovation to make sure that it does not threaten systemic stability. 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. China’s system of regulation includes a strict policy of “anything not specifically permitted is prohibited”. When asked what other countries could learn from China’s regulatory system, Liao Min, director general and acting head of the general office of the China Banking Regulatory Commission (CBRC), replied that “Chinese financial institutions needed CBRC approval to launch individual product types, making it nearly impossible for exotic financial instruments, such as the ones blamed for the subprime crisis, to exist in China”. As a result of this practice, “Chinese banks have emerged relatively unscathed from the global credit crisis …” (“China Says West’s Lack of Market Oversight Led to the Subprime Crisis”, Financial Times, 28 May 2006). Until South Korea accelerated the liberalisation of its financial system in the mid-1990s, its government maintained a list of acceptable banking practices. Financial institutions had to get regulators’ permission to do anything not on the list. We suggest careful consideration of the “anything not specifically permitted is prohibited” principle, and briefly elaborate on this below.

To implement a financial precautionary principle, several economists have proposed instituting a Financial Products Safety Commission, to inspect financial products both before they are issued and to continue testing and monitoring those that have been allowed to enter the market (Stiglitz 2009; Soros 2008).

There are a number of objections that may be raised to such a reform. First, it may be objected that a Financial Products Safety Commission will unduly stifle innovation, leading to significant losses to the economy. Yet, while it certainly must be the case that some financial innovations are quite useful, there is, in fact, very little evidence of either a theoretical or empirical nature that financial innovations in general have a significant positive impact on economic growth or development (Elul 1995; Frame and White 2002). And there is a great deal of evidence and concern that many financial innovations are largely motivated by the desire to evade taxes, avoid financial regulations, and create temporary monopolies that allow firms to charge excessive fees (Tobin 1984; Van Horne 1985; Tufano 2003).

Second, it may be objected that the process of applying for permission to market a new product will be too complex and difficult to structure. But financial regulators at the Bank for International Settlements (BIS), regulatory agencies, and investment bankers themselves have come up with elaborate check lists that they believe banks should implement in deciding whether to market or use new financial products, including demonstrating to themselves that their upper level management and clients can understand the real risks associated with financial products. Of course, these organisations are committed to self-regulation, and insist

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the banks simply adopt these “best practices”. But a Financial Products Safety Commission could insist that the issuers of new financial products provide convincing evidence to the commission of what the risks are, that their management has the capacity to manage the risks, and that their clients do so as well. In other words, if the banks can self-regulate sufficiently, then they and their products can be regulated by external regulators as well.

Third, it may be argued that we cannot identify the characteristics of financial innovations that are dangerous. But the banks and investment banks that created these “innovations” know quite well what aspects have made them so dangerous (CRMPG, III 2008).

These include, first, a high degree of leverage especially if it is embedded in instruments in complex ways. Second, these instruments are prone to periods of sharply reduced market liquidity. Third, the instruments may be characterised by a lack of price transparency. Fourth, significant maturity mismatches that lead to significant liquidity risk in a downturn; and fifth, pure complexity that will challenge the management’s and customer’s ability to manage the risks (CRMPG, III 2008).

The CRMPG committee proposed that only sophisticated investors be allowed to trade these instruments. Of course, this implies that these risky instruments can be identified as such. Having identified them, the Financial Products Safety Commission can furthermore determine whether they are too risky to be traded even by sophisticated investors. Of course, given the interconnectedness of different institutions and markets, the safe course of action would be in most cases to prohibit such products from being traded in the first place.

Indeed, there is now agreement that if regulators do not adequately prevent risk, they have to “test” the risk of banks and others not by asking what would happen to them if something bad happened, but rather what would happen if something bad happened to everybody so that there is a systemic problem and consequent liquidity evaporation and counter-party failures. No one does this now.

Fourth, it may be argued that the process of product approval could get corrupted; lobbying by financial firms, for example, could lead to the approval of products that should not be approved. Of course, the corruption of the regulatory process is always a potential danger in any field. The key to avoid this corruption is to have highly skilled, highly paid regulators with high status; oversight groups made up of a group of knowledgeable stakeholders and experts, including potential financial instrument users, academics and policymakers.

4 Increase Transparency
4.1 Prohibit the Sale of Financial Securities That Are Too Complex To Be Sold on Exchanges

Eighty per cent of all derivative products and 100% of the complex CDOs, CDSs and other exotic financial instruments implicated in the current crisis are traded off markets or over-the-counter (OTC). If regulators insist that all derivative securities must be exchange traded, those OTC securities that can be simplified


and commodified will shift to exchanges where they will be transparent, involve less counter-party risk, and be cheaper sources of finance. “Simpler products impose lower costs of credit analysis on end users, which in turn makes them less expensive sources of funding” (“Ruptured Credit”, The Economist, 17 May 2008). The most complex products, including CDOs, cannot be sufficiently simplified and will disappear from the market (“Fed Plan Is Spoilt by Its Backing of Hypocrites”, Financial Times, 15 April 2008, for one such proposal). Of course, investment banks and hedge fund traders would not meekly accept such a proposal since writing and trading complex derivatives OTC is a source of huge profits (“Clearing the Fog”, The Economist, 19 April 2008). A general ban on OTC derivative trading has one key advantage over attempts to prohibit specific products such as CDOs. Investment banks can evade regulations banning specific products or services by creating alternative products that are not identical, but perform the same functions. Prohibiting OTC products would eliminate this form of regulatory evasion. NFA supporters would argue that this reform would inhibit useful innovation, but it is now clear that the societal costs of such innovation – in terms of financial crises that cause or exacerbate real sector problems and require government bailouts – far exceed their possible social benefits (“A New Formula”, Financial Times, 1 October 2008).

4.2 Require Due Diligence by Creators of Complex Structured Financial Products

Require the investment banks 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. “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 cannot be done to regulators’ satisfaction, sale of these securities should be prohibited. A related requirement should be that the underlying mortgages in a complex security must be identifiable, and ultimate ownership of these mortgages must be clear. Where this is not the case, securities cannot be “unwound” in a crisis and the terms of the mortgage cannot easily be adjusted to stop the spread of defaults. Imposition of this requirement would probably close the market for CDOs and more complex securities based on CDOs.6 At present, investment banks claim to assure the safety of these assets through over-collateralisation. For example, investors can buy tranches of the expected cash flows from the mortgages in a CDO that will receive their payments before holders of riskier tranches do. Mathematical models are used to demonstrate the safety of such tranches under various adverse conditions, but these models have been shown to be totally unreliable under the threatening and uncertain conditions of the current crisis. A “due diligence” requirement would also reduce the deleterious role played by ratings agencies in the NFA.


5 Reduce Pro-Cyclicality
5.1 Restrict the Growth of Financial Assets through Counter-Cyclical Capital Requirements

A number of the previous suggestions might help restrict the excessive growth of financial assets in the boom. But they may not, by themselves, eliminate the excessive growth of financial assets. As a number of observers have noted, asset creation is extremely pro-cyclical (see, for example, Wray 2008). As asset prices rise, bank capital also rises, so banks can 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 capitalasset ratios (Adrian and Shin 2008). Spain experimented with such a policy. “Since 2002 the Bank of Spain has had something called a ‘dynamic provisioning’ regime, where bank provisions go up when lending is growing quickly... Over the cycle the effect is neutral, but the timing of provisioning should make the troughs less deep and the peaks less vertiginous” (“Spanish Steps”, The Economist, 17 May 2008). Though Spanish regulators did not impose this policy with sufficient vigour, its experience is suggestive.

5.2 Create a Bailout Fund Financed by Wall Street

When the Federal Deposit Insurance Corporation (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 (see Pollin 2005 for a general discussion of the transaction tax). The tax rate might be calibrated to generate about $100 billion in annual tax revenue. The fund would typically accumulate hundreds of billions of dollars in normal and boom times prior to the outbreak of a financial downturn. If effective regulations are put in place that 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.


We conclude with the important and obvious caveat that none of these proposals or any other serious new regulations will be implemented unless there is a dramatic change in the political economy of regulation. In particular, we will not be able to enact adequate reforms until two fundamental changes take place. First, the mainstream theory of efficient financial markets that is the foundation of support for the NFA must be replaced by the realistic financial market theories associated with John Maynard Keynes and Hyman Minsky. Recent events should convince any rational economist that the theory of efficient capital markets should be rejected once and for all, though it is far from clear that this ideologically grounded vision will in fact disappear. Second, there must be a broad political mandate in support of serious financial regulatory reform. For too long the Lords of Finance have corrupted the political process. Congress and the president have acted in recent decades as if they were paid employees of

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financial market interests, which many of them were. Perhaps Until we have regulatory institutions empowered by law to anger over the $700 billion dollars and the likely recession can control financial markets and force them to act in the public ingalvanise the needed political support for change. The key is to terest and we populate them with well-trained officials who bechannel the anger into pressure for a new “New Deal” in govern-lieve in serious regulation, we will continue down the disas

ment regulation of financial markets. trous path we have been following for the past three decades.


1 The Financial Times, 23 February 2009, reports that, among average opinion in Europe and the US, over 80% of the populace blame bankers and investment bankers for the crisis and 60% blame financial regulators, as compared with about 30% who place “primary or considerable” blame on home buyers.

2 But not all. For example, Brunnermeier et al 2009 seem to still be flirting with the “light-touch” approach.

3 This group includes representatives of the US top (former) investment and commercial banks such as Goldman Sachs, Lehman Brothers, Citibank, Merril Lynch, Bank of America, and so forth.

4 This draws on Crotty’s companion piece in this issue as well as Crotty (2008).

5 The $700 billion bailout programme does not contain such provisions. It has only weak language suggesting that new “golden parachutes” for executives leaving the firm might be in jeopardy. Existing golden parachutes would remain in place.

6 We are grateful to Rob Parenteau for suggesting this point about the need to be able to unwind mortgage-backed securities in a crisis.


Adrian, Tobias and Hyun Song Shin (2008): “Liquidity, Monetary Policy and Financial Cycles”, Current Issues in Economics and Finance: New York Federal Reserve, January/February.

Brunnermeier, Mark, Andrew Crocket, Charles Goodhart, Avinash D Persaud and Hyun Shin (2009): “The Fundamental Principles of Financial Regulation”, Geneva Reports on the World Economy, 11. (Preliminary Report).

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Crotty, James and Gerald Epstein (2009): “Avoiding Another Meltdown”, Challenge, January/February, Vol 52, No 1, 5-26.

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Essays from Economic and Political Weekly

A compilation of essays that were first published in the EPW in a special issue in May 2007. Held together with an introduction by Sekhar Bandyopadhyay, the essays – that range in theme and subject from historiography and military engagements, to the dalit viranganas idealised in traditional songs and the “unconventional protagonists” in mutiny novels – converge on one common goal: to enrich the existing national debates on the 1857 Uprising.

The volume has 18 essays by well known historians who include Biswamoy Pati, Dipesh Chakrabarty, Peter Robb and Michael Fisher.The articles are grouped under five sections: ‘Then and Now’, ‘Sepoys and Soldiers’, ‘The Margins’, ‘Fictional Representations’ and ‘The Arts and 1857’.

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Economic & Political Weekly

march 28, 2009 vol xliv no 13

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