Regulating the Financial Sector: A Modest Proposal

Building a new regulatory structure for the financial sector to replace the current, completely discredit regulatory structure will be a major task for the next administration and congress. However, at present there is a wide range of opinion over what needs to be done – believe it or not, there are those out there who think that what we need is less regulation rather than more. We’ll be pointing out serious proposals that we find out there. Note that linking does not necessarily constitute endorsement.

James Crotty and Gerald Epstein of the University of Massachusetts have put forth their nine-point plan for financial system regulation (abstract online, or download the PDF – it’s only 13 pages). Most economists (though perhaps not most people) would classify them somewhere on the heavy-handed end of the spectrum. The nine points, in summary, are:

  1. Restrict or eliminate off-balance sheet vehicles
  2. Require due diligence by creators of complex structured financial products (so if you create a CDO, you have to understand all the stuff in it)
  3. Prohibit the sale of financial securities that are too complex to be sold on exchanges
  4. Transform financial firm incentive structures that induce excessive risk-taking (so people who get big bonuses in good years have to pay them back in bad years)
  5. Extend regulatory over-sight to the “shadow banking system” (hedge funds, private equity, special investment vehicles)
  6. Implement a financial pre-cautionary principle (like with drugs, innovations have to be approved first)
  7. Restrict the growth of financial assets through counter-cyclical capital requirements (um … read the proposal yourself)
  8. Implement lender-of-last-resort actions with a sting (punish the people responsible when you bail out their companies)
  9. Create a bailout fund financed by Wall Street (use a securities transaction tax to create a bailout fund to use next time)

I’m skeptical about 4 and 8 – human ingenuity is perhaps nowhere so unparalleled as in the creation of executive compensation schemes designed to avoid any possible constraint. 3 and 6 will be extremely controversial and can be seen as infringements on freedom of contract, at least where “sophisticated” investors are concerned. 9 is also controversial, although a variant of it was actually in the $700 billion bailout bill. But it doesn’t hurt to start thinking about it now.

2 thoughts on “Regulating the Financial Sector: A Modest Proposal

  1. Shareholders ought to demand some version of #4, perhaps a compensation structure where bonuses are paid out over a period of 5-10 years, and where what hasn’t been paid out yet gets forfeited if it turns out that the work that earned the bonuses laid time bombs that exploded later (e.g., the work of AIG’s shop in London). This would probably lead to a market for instruments to hedge the risk of any such time bombs exploding, but that might be a useful innovation.

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