Ending the Financial Arms Race
People often ask if regulators and legislators have fixed the flaws in the financial system that took the world to the brink of a second Great Depression. The short answer is no.
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Legislation and regulation produced in the wake of the crisis have mostly served as a patch to preserve the status quo. Politicians and regulators have neither the political courage nor the intellectual conviction needed to return to a much clearer and more straightforward system.
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Banking regulation has evolved from a small number of very specific guidelines to mind-numbingly complicated statistical algorithms for measuring risk and capital adequacy.
Legislative complexity is growing exponentially in parallel. In the United States, the
Glass-Steagall Act of 1933 was just 37 pages and helped to produce financial stability for the greater part of seven decades. The recent Dodd-Frank Wall Street Reform and Consumer Protection Act is 848 pages, and requires regulatory agencies to produce several hundred additional documents giving even more detailed rules. Combined, the legislation appears on track to run 30,000 pages.
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The problem, at least, is simple: As finance has become more complicated, regulators have tried to keep up by adopting ever more complicated rules. It is an arms race that underfunded government agencies have no chance to win.
Even back in the 1990’s, regulators would privately complain of the difficulty of retaining any staff capable of understanding the rapidly evolving derivatives market. Research assistants with one year of experience working on derivatives issues would get bid away by the private sector at salaries five times what the government could pay.
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Admati and her colleagues recommend requirements that force financial firms to generate equity funding either through retained earnings or, in the case of publicly traded firms, through stock issuance. The status quo allows banks instead to leverage taxpayer assistance by holding razor-thin equity margins, relying on debt to a far greater extent than typical large non-financial firms do. Some large firms, such as Apple, hold virtually no debt at all. Greater reliance on equity would give banks a much larger cushion to absorb losses.
The financial industry complains that efforts to force greater equity funding would curtail lending, but this is just nonsense in a general equilibrium setting. Nevertheless, governments have been very timid in advancing on this front, with the new Basel III rules taking only a baby step toward real change.
Of course, it is not easy to legislate financial reform in a stagnant global economy, for fear of impeding credit and turning a sluggish recovery into a full-blown recession. And, surely, academics are also to blame for the inertia, with many of them still defending elegant but deeply flawed models of perfect markets that create an illusion of safety for a system that is in fact highly risk-prone.
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"Ending the Financial Arms Race" by Kenneth Rogoff | Project Syndicate
http://www.project-syndicate.org/commentary/ending-the-financial-arms-race-by-kenneth-rogoff