New Research in Financial Regulation

By James Kwak

Not surprisingly, there is a great deal of interesting research being done in the area of financial institutions, systemic risk, and regulatory reform. Last week I had the pleasure of attending a workshop for junior law professors held by the Insurance Law Center of the UConn Law School, where I am a professor. The workshop featured a long list of provocative and weighty papers at various stages of completion. Here I just want to point out a few that are fully drafted and available on SSRN.

Robert Weber presented what should be the canonical paper on stress testing as applied to financial institutions, which has been going on for a while but became front-page news in 2009, during the financial crisis. He traces the history of stress testing back to its engineering roots in Renaissance Italy with, perhaps unsurprisingly, Leonardo da Vinci. Weber is critical of box-checking stress testing, but argues that stress testing  can be useful as a way of encouraging or inducing bank executives and risk managers to more closely investigate their assumptions and beliefs and ultimately create a “morality of quantitative skepticism.”

Gallons of ink have been spilled over the Orderly Resolution Authority established in Title II of the Dodd-Frank Act, generally over whether and how it would be used in a crisis. In 13 Bankers, Simon and I expressed skepticism that it would be used, for practical and political reasons. Joshua Mitts’s paper takes the novel approach of looking at how OLA affects managerial incentives in the pre-crisis period, arguing that it encourages bank executives to design their firms in such a way as to maximize the chance of a taxpayer bailout. This would lead them to increase their exposure to other large financial institutions and to increase the correlation of their asset portfolios with those of other large firms.

Mehrsa Baradaran takes a historical view in her paper, which is about the social contract between banks and society as expressed through banking regulation. She begins with the Hamilton-Jefferson debates over banks (which is also where we began 13 Bankers) and covers the history of banking regulation (or non-regulation) up to the 1930s, which represented the most thorough codification of the social contract: the government needs banks, but banks also need the government. The past few decades, however, have seen an erosion of this social contract, giving banks the benefits of government sponsorship and support without the obligations necessary to ensure that they serve societal ends. Baradaran argues that banking regulation should incorporate a robust public benefit test to ensure that banks are in fact helping households, the economy, and society at large.

There are other interesting papers that are sure to come out of this workshop. One small side benefit of the financial crisis has certainly been the increased attention to the financial sector and the risks it presents to the rest of us.

15 responses to “New Research in Financial Regulation

  1. Per Kurowski

    “arguing that it encourages bank executives to design their firms in such a way as to maximize the chance of a taxpayer bailout”

    “To maximize”??? That is pure bullshit! A taxpayer bailout might save bankers from undesired consequences, but it does not provide them a source of income.

  2. Bruce E. Woych

    The links are valuable references: and the historic perspective is most interesting. Some empirical examples of how regulatory reform tends advantage TBTF would be interesting, along with a comprehensive categorization (needed) to designate distinctive types of reform and counter-reform legislation would be very helpful. The term “regulation” itself appears to be Too big To Understand…out of direct context. The term defies definition until it is contextualized, and indiscriminate abuse of the ambiguity of the term has become a ritual obfuscation in political camps.
    Meanwhile: Your quote:
    “One small side benefit of the financial crisis has certainly been the increased attention to the financial sector and the risks it presents to the rest of us.”
    Is the UNDERSTATEMENT of the decade! But oddly enough appears to perhaps be generally true of the general popular expanse on critical knowledge, concern and watchdog agency across the board on an all too concentrated TBTF Washington Consensus!

  3. Bruce E. Woych

    http://www.chomsky.info/articles/199107–.htm

    A quote from Force and Opinion
    Noam Chomsky
    Z Magazine, July-August, 1991 (from an essay unrelated to Finance per se; yet the words are strikingly appropo):
    “The recent events of Eastern and Central Europe are a sharp departure from the historical norm. Throughout modern history, popular forces motivated by radical democratic ideals have sought to combat autocratic rule. Sometimes they have been able to expand the realms of freedom and justice before being brought to heel. Often they are simply crushed. But it is hard to think of another case when established power simply withdrew in the face of a popular challenge. No less remarkable is the behavior of the reigning superpower, which not only did not bar these developments by force as in the past, but even encouraged them, alongside of significant internal changes.”
    ==================================
    The First Bank of the United States:
    On the political opposition to creating the first central bank (1791) on the British Institutional model:

    http://en.wikipedia.org/wiki/First_Bank_of_the_United_States

    “Officially proposed to the first session of the First Congress in 1790, Hamilton’s Bank faced widespread resistance from opponents of increased federal power. Secretary of State Thomas Jefferson and James Madison led the opposition, which claimed that the bank was unconstitutional, and that it benefited merchants and investors at the expense of the majority of the population.”
    [and]
    “Like most of the Southern members of Congress, neither Secretary of State Thomas Jefferson nor Representative James Madison had any particular interest in two of Hamilton’s tripartite recommendations: the establishing of an official government Mint, and the chartering of the Bank of the United States. They believed this centralization of power away from local banks was dangerous to a sound monetary system and was mostly to the benefit of business interests in the commercial north, not southern agricultural interests, arguing that the right to own property would be infringed by these proposals. Furthermore, they contended that the creation of such a bank violated the Constitution, which specifically stated that congress was to regulate weights and measures and issue coined money (rather than mint and bills of credit).”
    ================================
    The Second Bank of the United States

    http://lehrmaninstitute.org/history/Andrew-Jackson-1837.asp

    “Jackson came into presidency in 1829 determined to eliminate the national debt, the management of which was one of the purposes of the national bank. “Jackson had two purposes in ridding the country of debt,” wrote John Steele Gordon. “The first, of course, was that he thought debt was bad in and of itself. He called it a `national curse’ in his first run for the presidency in 1824. But he thought that the institutions and the people who benefited from it were a national curse as well. `My vow,’ he pledged, `shall be to pay the national debt, to prevent a monied aristocracy from growing up around our administration that must bend to its views, and ultimately destroy the liberty of our country.” “

  4. Sadly there are no Thomas Jefferson’s or Andrew Jackson’s in Amerika today. All our socalled politicians are spaniels to one or another predatorclass oligarch doing predatorclass bidding while in office only to rotate into lucrative consulting or board or lobbying position when they leave office. None of our socalled politicians hold any concern or desire to advance the best interests of the people. Our socalled politicians (with maybe a few exceptions) are in bed with and beholden to the predatorclass exclusively! So while all these erudite papers proposing solutions to our current panjandrum and kleptocratic financial system are interesting and viable options for righting the horrible wrongs of the TBTF oligarchs – and inspire vibrant discussion – in practical reality – NOTHING is going to change. The government is broken. The financial system is perverted and (without the largess of central banks printing money out of the myst and funneling it into the offshore accounts of the den of vipers and thieves in the finance oligarchs and heaping the debt on people) – the financial system is also broken.

    Nothing will change unless and untill the people demand REAL change. This nation was born of revolution. Nothing less will save what little is left of America from the insatiable greed, ruthlessness, and criminality of the predatorclass.

    Burn it all down! Reset! It’s the only option!

  5. Anonyomouse

    When I was a kid I felt like Tony, I said to myself I could have been a George Washington, or an Abe Lincoln. But I looked around at all I saw, and said to myself, but everything been done, we just sent a man to the moon I mean what more could you want to do, and left it at that.
    But as I grew up I started to realize it wasn’t as much as new things needed to be done, but bad people put in there place so as not to abuse technology and resources. Our miserable hypocritical fiend Annie is a perfect example of just such bad like minded thinking and doing people, that it’s their way or the highway because their god is a piece of paper with numbers and words on it and since they control plenty of it, they are entitled to abuse technology and resources.
    It’s been going on since the first bank of the U.S. was formed. Most currency of the day was Spanish silver which had been spewing from a South American volcano and was stamped and then shipped around the world. The Georgia territory was purchased for $3 million of gold by King George, but instead of paying in gold he sent over a printing press and was paying the locals in cash. It didn’t take the locals very long to figure out that the king was simply inflating the currency and they went back on the agreement and wanted to be paid in gold. The problem was that the Indians had run up a hugh debt they could not pay off and there was no trust in gvt.
    So the first bank of the U.S. was formed and the $3 million payment was made by the new gvt from bonds which were issued. Shortly afterwords it was agreed the Indians would have to pay by forfeiture of the land and since they could not be civilized (The Annies of the world), they had to be removed which lead to the trail of tears and the Louisiana Purchase which paid for their removal.
    Today we have similar problems with all of Annie’s evils penetraiting the globe and then taking the other hypocritical side just because they can, for now. And that’s the way it must be until the balance between good and evil matures to overwhelm the evil Annie’s and put them in their place once and for all.

  6. Anonyomouse

    Oh yea, and I agree with Hamilton that debt is a bad thing that makes bad people do bad things because of their increasing need for it to fund their bad habits and beliefs, and yes Annie it’s you again.

  7. Oh, the best laugh of the day, thanks MouseTurd – now I know for certain that you got no real information about who I really am and how my life has been altered by the secret monkey brain goon squad who makes it all up – like you do – because I made it public in 1991 that I read a certain FORBIDDEN book…

    LMAO…oh yeah, I brought down USA with a CURE for greed….

    You would NOT believe what was planned for “ploughshares” after the Moon Walk….but they went with creating the Gowanus Creek water, instead, and making deals with cannibals to grow the opium biz…

    It’s actually pathetic how dumbed down you are…stupider than the good lord made you…your tax $$$$ at work.

    Stay out of “education”, boyz….

  8. bayardwaterbury

    Interesting article. I would point out that I view the latest drop in markets as the rebellion of the financial oligarchs at the idea of Bernanke giving up his role as “Sugar Daddy” in the QE regime. The last thing the massive banks want to see is Bernanke to cut off their endless supply of gambing support by his zero rate policy and buying bonds (and thus automatically building a profit baseline fo the TBTF culprits). Academia has been obviously and realistically occupied (or obsessed) in its ongoing analysis of the current state of the role of these financial behemoths. James, you and Simon have tried very diligently to add a serious element of rational thought to the ever hyperbolic debate over how to deal with the current bubble and bust mentality and how it affects public policy. While the FED has done its damnedest to move our economy forward, I would argue that its efforts have been far to narrow, thus creating a new bubble (which was partially deflated by Ben’s Wednesday speculations about the future of these agressive FED programs. It comes as no surprise to me that they have had a limited, and perhaps even perverse affect on the economy at large, both national and global (note that apparently it has had salutory effect on the rest of the world, and hardly any at all). Regardless of the ink, tears, etc., spent on public banking policy and regulation, for a fact little of good has happened thusfar. Dodd/Frank is still in formulation, and even it has come under massive criticism for its legislatively engineered loopholes. And where has all of this left us? We are still living in a state of economy on the brink of potential disaster every day. I worry that when the FED finally “pulls the carpet out from under the economy, there could be nearly instantanious massive collapse.

  9. @waterbury – like, duh, if the FRB pulls the magic carpet out from under the economy it would collapse since they are the “private” creators of that economy riding on their magic carpet…

    unless of course, they were busy like Santa’s elves building another “economy” that will be revealed after this one disappears..???

    Didn’t think so…

  10. Anonyomouse

    Hey man, I told you about living in the US of A, don’t you know i’m against it a lot. But you seem to be on the wrong side of nature on this one. But like Duh? Just don’t sucker punch me next time and I won’t treat ya so bad.

  11. Anonyomouse

    And I really don’t need to know who you are, to be able to determine that you are troubled soul, and once troubled, don’t ask why, just kiss your ass goodbye.

  12. bayardwaterbury

    With what I was hearing today regarding the hold that the world’s biggest banks have on the world economy, the entire house of cards will soon come crashing down, with or without the FRB’s assistance.

  13. Moses Herzog

    I heard that some of these banks have been doing their best to manage this….. crap. It is a “Whale” of a job that requires “innovative” “highly intelligent” men such as Jamie Dimon. I know these TBTFbanker CEOs are “innovative” because “journalists” (think Sorkin and the initials A.R.S.) who spend their time licking the anal regions of these TBTFbankers keep telling me repeatedly ad nauseam they they are “innovative”, and Sorkin (initials A.R.S.) wouldn’t just transcribe TBTFbanker propaganda just to sell a book…… I mean do you really think you have the “ability, brains, special cognitive powers” to lose $840million on a sewer project like the “masters of the universe”!?!?!?!? http://blogs.wsj.com/moneybeat/2013/06/05/how-much-did-jefferson-county-cost-j-p-morgan/
    I mean, come now, really??? Men like Jamie Dimon are “special” and they may run overseas and blow England taxpayers’ money out of their A S S on sewer projects in England if we aren’t nice to them here and give them cart blanche to spend taxpayer money on executive bonuses. And what would we do THEN!?!?!?!

    But then again, the “brain power” and “innovation” it took guys like Dimon to lose $840million on a sewer project was probably small compared to the “brain power” and “innovation” it took for Dimon to supervise the loss of $6 billion. I mean, let’s give credit where credit is due….. I’m referring to Dimon’s brain not a city sewage system.

  14. Moses Herzog

    These guys like Lloyd Blankfein are doing their best to “provide capital” for important infrastructure and jobs:

  15. Moses Herzog

    Here’s another one that’s good at showing how “innovative” the guys at Goldman Sachs are. If you don’t want extra background you can “fast-forward” or jump to the 1minute10second mark: