Important Principles for a New Financial Regulatory System

Last Updated Apr 18, 2009 10:45 PM EDT

Now that the Wall Street we all once knew is over, the key question for financial regulators becomes how best to regulate the financial world of the future, especially in light of concerns about large risks to the system that Mark identifies. To answer that question, here are three principles that I believe regulators should keep in mind.

1. Small is beautiful

Regulators should embrace the fact that, going forward, smaller and more nimble financial services boutiques will increasingly provide some of the services provided by Wall Street. Right now, many smaller firms are taking employees and business from the investment banking and mergers and acquisitions units of the big banks.

Although these companies are often private and not as transparent as public companies, we needn't worry. Private partnerships have their own style of governance that may be stronger than those of publicly listed financial corporations. For one thing, employees of these companies stand to lose more of their own money and therefore may be more responsible.

The beauty of these types of firms is that not only are they smaller, but that they also borrow less -- meaning that they pose much less of a risk to the financial system that than the overleveraged big banks did.

2. Overdependence breeds disaster

Mark says that the interconnectedness of financial companies is a major danger because if one fails, losses will be felt throughout the economy. But interdependence is the real problem. Our economy became too dependent on banks to make loans and supply credit, so when they ran into trouble, we all did. To reduce overdependence on banks, regulators should help to facilitate the creation of nontraditional companies that make business and consumer loans. So long as they are properly regulated for safety and soundness, companies like Wal-Mart should be welcomed to the loan-making business as a way to reduce our dependence on traditional banks.

Another way to reduce dependence on banks is to encourage more peer-to-peer lending, which uses on-line networking to allow small loans to be made. Peer lenders have facilitated hundreds of millions in dollars in small loans and often at better rates than traditional banks or credit cards. Currently, this type of lending falls outside the traditional regulatory framework applicable to securities or to banks, and in November 2008 the SEC ordered one peer lending company to cease and desist its activities. Regulators should act to ensure that peer lending does not hurt small lender or borrowers, but they should act quickly as the need for small loans has probably never been greater than it is now.

3. Derivatives do work

A problem underlying the financial crisis was that banks could earn large fees from securitizing and selling mortgage-backed bonds without necessarily exposing themselves to risk. And because these bonds were labeled as "investment grade" by credit ratings agencies, investors were unduly attracted to them. Over time, these bonds were used not only to transfer risk, but to hide it.

Instead of transferring risk through securitization, risk can be transferred using non-exchange-traded derivatives. With buyers and sellers each exposed to risk for the life of the contract, each side has an incentive to be prudent. Derivatives also do not receive credit ratings and so don't create an illusion of safety. As a result, the vast majority of derivatives obligations were met in recent years. By contrast, the securitization market nearly came to a complete halt, and toxic structured securities continue to plague banks.

Regulators should continue their productive role in encouraging derivatives market participants to increase transparency and improve other aspects of derivatives market stability. A more developed market for credit derivatives could also help investors better price bonds, including the type of structured bonds underlying the crisis. This process would be assisted, too, if regulators see to it that the role of credit rating agencies is diminished greatly so that parties don't rely as much on structured securities to transfer risk.

Follow Blog War on regulating the financial sector:
  • Houman Shadab

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