Why We Need Smart Financial-System Regulation Now

(MoneyWatch)  Houman makes a case against extending regulation to hedge funds by looking at what happened under the existing regulatory structure. But as we all know, past performance does not necessarily predict future behavior, particularly when the underlying regulatory structure changes (and we can certainly expect chagnes in the future). So past regulatory behavior doesn't necessarily predict what will happen when hedge funds are one of the few remaining places where money can be put at risk.

There are two types of policies that we now need to put in place. The first should protect investors from excessive levels of risk, and the second should protect the entire economy from financial collapse. In the first case, my worry is that as regulation closes some high-risk, high-return investment opportunities, money seeking those high returns will find its way into unregulated sectors. I'm not concerned about people who can afford to lose their entire investment, and who do not put everyone else in danger when they do so.

My concern is with funds that are handled by money managers whose compensation structures may cause them to seek higher risk investments than their investors would prefer. Investors in pension and other funds, for example, are restricted from withdrawing their money and moving it elsewhere in the short run, and they may not even be fully aware of the risks their managers are taking due to the difficulty of gathering and interpreting the relevant information. So they need to be protected.

Houman argues that the information problem isn't so severe, and notes that some institutional investors seemed to be aware of the risks prior to the crash. But if this had been generally true we wouldn't have the crisis we're in, so I'm not so sure that pointing to the professionals gets us very far. But again, it's the smaller investors I'm more worried about. Whether or not the professionals got it right -- and I don't think they did -- individuals certainly didn't have the information they needed to assess the risks they faced. After all, the whole point of having ratings agencies was provide a reliable risk assessment to people who didn't have the same information as the insiders selling the assets. We know now that those ratings weren't reliable at all.

As a result, individuals must be protected through regulation to ensure that they don't unexpectedly lose everything. And as I've noted previously, I believe this requires broadening and extending regulation that protects individuals to all sectors, including hedge funds.

Addressing systemic risk
These regulations reduce risk for individual investors, but as a macroeconomist, I'm also concerned about formulating policy that reduces risks to the system as a whole. We need to prevent individual banks from becoming too big, too interconnected, and too leveraged to fail, and we need to prevent the dangerous build-up of risk in particular areas of the financial system. To accomplish this, we could adopt one of the many proposals for somehow taxing the accumulation of risk. For example, professors Viral Acharya, Matthew Richardson, and Nouriel Roubini write in today's Financial Times that we could:

Quantify the systemic risk of large, complex financial institutions and "tax" their contributions to systemic risk through capital requirements, or deposit insurance fees, or mandatory insurance purchases from private and public sectors. The need for a systemic risk regulator who performs this role and manages the failure of these institutions is only underscored by the growing size of the few remaining operators in the financial arena.

This quantification of risk is what I was getting at in my proposal for an interconnectedness measure, but that's just one of many possible approaches. The main thing is to find a way to accurately monitor risk, and then to impose a tax that bites harder and harder as risk increases.

In addition, as those professors note, we also need to provide more reliable information for investors by having a central clearinghouse and/or registry for the trading of derivatives like credit default swaps and the use of off-balance-sheet transactions. This won't completely solve the information problem -- individual investors will still need protection against the problems that occur when they don't have as much information as the sellers -- but it would certainly be a good step in the right direction.

Follow Blog War on regulating the financial sector:

• Monday, April 13, Mark Thoma: Avoid the Next Crisis: Regulate Shadow Banks
• Monday, April 13, Houman Shadab: Don't Blame All the Shadow Banks
• Tuesday, April 14, Mark Thoma: Don't Leave the Door Open to Another Financial Crisis
• Tuesday, April 14, Houman Shadab: Why Too Much Regulation Increases Risk
• Wednesday, April 15, Mark Thoma: Getting in Front of the Next Crisis Requires Broad-Based Regulation
• Wednesday, April 15, Houman Shadab: Why Didn't Regulators See the Current Crisis Coming?
• Thursday, April 16, Mark Thoma: Why We Need Smart Financial-System Regulation Now
• Thursday, April 16, Houman Shadab: Shadow Banks Don't Threaten Healthy Banks
• Friday, April 17, Mark Thoma: Why Self-Regulation of the Financial System Won't Work
• Friday, April 17, Houman Shadab: Important Principles for a New Financial Regulatory System