Effective Regulation: Parts 1 - 5

In five papers in a series on financial-market regulation, the Global Markets Institute analyzes how the market crisis has come about and offer thoughts on how to prevent another.

The first paper analyzes how the global savings glut fed the housing bubble, while securitization reduced the effectiveness of firebreaks in the global financial system. At the same time, regulation lowered system-wide capital levels, impeding the ability to manage large shocks. The spread of complex financial holding companies caused further damage. We offer four principles for rebuilding.

The second paper looks at the challenge of managing global markets with local rules, and argues that governments should seek to attract market activity, to allow better control of risk and positive spin-offs like job creation and tax revenues.

The third paper outlines proposals to reduce arbitrage opportunities and strengthen controls on transfers of risks. The paper illustrates these proposals with case studies of some key arbitrage problems, and shows how helping to restore transparency about financial institutions could reduce the likelihood of a similar market crisis in the future.

The fourth paper discusses the challenges of turning good ideas into good outcomes. It aims to focus the debate on reform beyond individual issues, and to look instead at how the whole financial system can be altered to reduce systemic risk and improve overall economic performance.

The fifth paper discusses how financial reform must effectively eliminate the concept of “too big to fail” if it is to succeed. One of the most promising proposals for this is contingent capital. Structured as debt that converts into common equity when a firm is in financial distress, contingent capital is a form of self-insurance for systemically important firms. Correctly structured, it would force troubled firms to recapitalize early and quickly, and at the expense of shareholders and contingent bondholders -- not taxpayers. Back-tests indicate that contingent capital triggered by a process modeled after the U.S. “stress test” would have allowed the firms that were included in the stress test to recapitalize without taxpayer funds. Proper structuring is essential; done right, contingent capital could be more effective in improving financial firm incentives than a simple increase in regulatory capital requirements would be. 



>> Effective Regulation: Part 1 - Avoiding Another Meltdown March 2009 [PDF, 499 KB]

>> Effective Regulation: Part 2 - Local Rules, Global Markets March 2009 [PDF, 545 KB]

>> Effective Regulation: Part 3 - Helping Restore Transparency June 2009 [PDF, 538 KB]

>> Effective Regulation: Part 4 - Turning Good Ideas Into Good Outcomes October 2009 [PDF, 328 KB]

>> Effective Regulation: Part 5 - Ending "Too Big To Fail" December 2009 [PDF, 316 KB]