One positive feature of a banking crisis is that it sets the stage for banking reform. The anti-regulation lobbyists are weakened, the public’s attention is focused on something that is usually too wonkish or technical to be of interest during normal times, and Congress and the Administration are interested to solve what is now the nation’s largest problem. These opportunities thankfully do not come around frequently, and when they do, the authorities typically take advantage of them to debug the antiquated regulatory framework that has evolved since the last crisis. These efforts serve to put new teeth into the law (for inevitably the teeth inserted during the last crisis have been worn down by the constant pressure of lobbyists) and bring the law into line with advances in technology and changes in market practices. It will be important for investors in financial institutions to follow this debate and perhaps chime in, since the resulting framework will dictate what kind of activities banks, insurance companies, and securities companies can do and how much capital they must set aside against the risks they enter into.
The process in the U. S. started in earnest two months ago with the release of the a report called Financial Reform: A Framework for Financial Stability prepared by the Group of 30 under the direction of Mr. Paul Volcker. Mr. Volcker, as everyone knows, was the Chairman of the Board of Governors of the Fed before he was replaced by Alan Greenspan. Now he is, among many other things, the Chairman of the Board of Trustees of the Group of 30 and a senior policy advisor to the Obama administration.
This report is important, not only for the quality of its analysis and recommendations, but also because it is a sort of semi-official blueprint for the reforms that the Obama administration wants to pursue, since Mr. Volcker has an official role as adviser to the government in these matters. Now the process of reforming the legal framework of the financial sector is in full swing with (it seems like) almost daily congressional hearings and press conferences on the topic.
The debate over financial sector reform is being played out in two main areas and many smaller ones. The main areas of debate are (1) what should be the philosophical orientation or style of the new regulatory framework, and (2) which institution or institutions should be responsible for its implementation. The smaller areas of debate concern such things as what to do about fair value accounting, money market mutual funds, capital adequacy, credit default swaps, etc. This paper introduces the topic of the philosophy of the new regulatory framework and suggests that the debate will take place around two possible philosophies of financial regulation. In another paper, which will appear in a couple of days, I will discuss the pros and cons of the two philosophies.
Two main philosophies of regulation are being discussed. The first, is a philosophy centered on the concept of systemic risk of the financial system. This framework is recommended by the Volcker report. It contemplates the establishment of a systemic risk regulator, which could be the Fed or some other institution, that is tasked with regulating all financial institutions, whether they are banks, hedge funds, insurance companies or other; that have been declared to be “systemically important” that is, so large that they could destabilize the financial system if they went under. Too big to fail, in other words.
These institutions would be subjected to close regulation in order to limit the risks that they take and thereby reduce the likelihood that their failure would constitute a “systemic event”, that is, a failure whose domino affects would cause large losses in other financial institutions and a disastrous decline in economic activity. (This is, of course, what is happening now and is something that has not occurred in the U. S. since the Great Depression.) This close regulation would include restrictions on the businesses that Too Big to Fail (TBTF) institutions could be active in. While the nature of these restrictions has not been worked out yet, one can imagine for example, that an investment bank that had grown too large and risky would be required to limit the underwriting of certain kinds of risks, like credit default swaps, perhaps, or that a commercial banking subsidiary of such an investment bank would be prohibited from lending to the parent, since that would expose the bank’s depositors to the risks of the investment bank parent. Other institutions, that is, those who are not deemed to be too big to fail, would be subject to a more conventional regulation, by the banking regulator, securities regulator or insurance regulator, depending on the kind of institution.
The second regulatory philosophy is one that, rather than focusing on how to regulate institutions that are too big to fail, tries to limit the number of institutions that get to the size and level of riskiness that causes them to be a threat to the whole economy. It is a more conventional approach, focused more on protecting depositors and the integrity of the payments system, coupled possibly with some notion of size restrictions on the different kinds of financial institutions.
 I am indebted to Stuart Mackintosh, Executive Director of the Group of 30, for his explanation of some of the concepts contained in Financial Reform.