How to (not) regulate financial markets

Avinash Persaud makes some excellent points and has some very useful suggestions.  A key point that I have not seen made elsewhere: since the whole point of financial regulation is to counteract market failures in financial markets, it makes no sense to base regulation on the prices that those same markets generate (as is done when we use mark-to-market accounting or rely on market prices of risk in risk models).

Comments

[Great Zamfir]

"The third pillar is requiring banks to pay an insurance premium to tax payers against the risk that the tax payer will be required to bail them out. If such a market could be created, it would not only incentivise good banking and push the focus of regulation away from process to outcomes, but it would provide an incentive for banks to be less systemic."

I loved this one, but it is a bit unclear to me how you could set up a market for this, or otherwise determine fair prices.
Any ideas?

[claudio]

How to (not) regulate the labor market (in Brazil): http://portalexame.abril.com.br/static/aberto/newsletter/news_30042008.html

[Per Kurowski]

To Great Zamfir. It is actually quite straithforward. Do not use the market bit size. Just follow the tradition of not putting all your eggs in the same basket and therefore create a progressive tax on the size of the banks. The larger the bank, the more it will hurt if it fails, so the more it should pay in insurance premiums.

[Per Kurowski]

Avinash Persaud also mentions that “the secondary objective, which is to avoid the discouragement of good banking” and in this he is getting much closer to what I have held for over a decade now, being what is the use of a bank regulatory system which only objective is to avoid a bank crisis since avoiding bank crisis per se cannot be the prime objective for our banks?

The following brief comment might better summarize what I mean.

Does prudence in banking really have to mean purposelessness?

What is more prudent for the bank regulators, to work exclusively at avoiding the default of banks and the occurrence of a bank crisis, or to ascertain that the banking system serves a purpose for the society?

These days when it has been demonstrated that the bank regulators are failing in their self imposed limited scope of functions; and indeed through the creation of the current structure of minimum capital requirements for the banks and the appointment of the credit rating agencies as risk commissars have themselves contributed to create new systemic risks, is it not time for us to take a big step back and, before digging us deeper in our regulatory hole, ask ourselves what is the purpose of our banks?

Aren’t you as fed up as me having a purposeless banking sector? If we absolutely have to live with risk avoidance based regulatory system, can’t we at least start measuring units of default risk in terms of decent jobs created, youngsters educated or environmental threats avoided?

Risk is the oxygen of development and so please let us not kill or even define risk taking!

[Per Kurowski]

But when Avinash Persaud says “there are few crises I have known from the inside that would not have happened if only there was more disclosure. People knew that sub-prime was a poor risk – it is called sub-prime, after all” there I do not agree.

First of all on a general point he seems to ignore that “to err is human” and on a more technical point he is factually wrong as you could indeed structure very prime securities around subprime mortgages but what happened in this case is that the official risk commissars the credit rating agencies, being human, erred, big, not noticing that the new batch of subprime mortgages being sent up had nothing to do with the older batches.

[Per Kurowski]

And when Avinash Persaud says “Almost every economic model will tell you that if all the players have the same tastes (reduce capital adequacy requirements) and have the same information (public ratings, approved risk-models using market prices) that the system will sooner or later send the herd off the cliff edge (Persaud 2000). And no degree of greater sophistication in the modelling of the price of risk will get around this fact”, the number one question that springs to ones mind is about “the inappropriateness of the financial regulators”. Who is going to tackle that one?

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