The Worlds Leading Economic Theorists Finance Essay - Free Essay Example

Sample details Pages: 12 Words: 3464 Downloads: 7 Date added: 2017/06/26 Category Finance Essay Type Analytical essay Did you like this example? While the book is arguably aimed more at an academic audience, the material is clearly accessible to policymakers and regulators. Just this past month, in recognition of the one-year anniversary of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the NYU Stern School and the Pew Charitable Trusts put on a conference in Washington, D.C. During the entire day of proceedings, sitting toward the back was a senior staffer of the House Committee on Financial Services reading Balancing the Banks. When I asked him what he thought of the book, he commented on how insightful it was and that the book had given him pause to thought. The four chapters are organized as follows. In a brief chapter 1, the authors lay out their case for regulation of the banking sector and how things had gone wrong leading into this crisis. An important argument made by the authors is an extension of Dewatripont and Tiroles (1984) representation hypothesis to the case of all finan cial institutions, in particular, the shadow banking system. The theory basically argues that prudential regulation should replicate the corporate governance at nonfinancial firms in terms of mimicking the market discipline imposed by debtholders. Because of the government safety net and the implicit government guarantees, this discipline is eroded in the financial sector. Chapter 2, and by far the longest essay, is written by Tirole, and focuses both on what he considers to be the major causes of the crisis and, given these causes, how the financial system should be reformed. The chapter describes a whos who of possible suspects for what caused the financial crisis. The most interesting part of this discussion is less Tiroles naming of these suspects and, instead, Tiroles take on why they are suspects. For the reader interested in the global financial architecture, the chapter provides a unique look into the mind of one of the worlds leading thinkers in this area. Tiroles follow -on long list of reforms and motivation for these reforms allows one to compare Tiroles view of financial regulation to that of other academics, such as NYU Sterns work (Viral V. Acharya and Matthew Richardson 2009), Markus Brunnermeier et al. (2009), and the Squam Lake Group (2010) among others, and the actual enacted legislation both in the United States and abroad. The third chapter by Rochet takes a more targeted look at prudential bank regulation with a particular emphasis on the Basel Accords. This is a must read for anyone interested in the Basel accords and why these accords were inadequate for our financial system. In fact, I view this chapter somewhat as an indictment of the entire Basel approach to prudential bank regulation. While Rochet does not go as far as to argue for scrapping them, his suggested reforms are consistent with a complete overhaul of the system currently in place. As described below, he would most likely not be supportive of Basel III. The final c hapter by both Dewatripont and Rochet follows on from the criticisms provided in the prior chapter on the Basel Accords. In particular, the chapter takes a banking crisis as given and then discusses how distressed banks should be treated in this crisis. The authors discuss a special bankruptcy regime for financial institutions and some of the challenges that arise within an international setting. As discussed below, a key theme of this chapter is a more systemwide approach to measuring and managing risks of financial institutions. My review will cover three areas. First, I will try and put into perspective the major conclusions of the authors on financial sector regulation. Second, I will provide a few critical remarks on the chapters. Third, and perhaps equally important, it should be noted that the authors wrote these essays prior to the enactment of major financial regulation such as the Dodd-Frank Act and the new Basel III accords. It seems worthwhile therefore to see whether some of the authors ideas ended up being part of these historic legislations. Financial Sector Regulation A consistent theme throughout the three main essays is that the purpose of prudential regulation is twofold: (1) protect depositors, holders of insurance policies, or investors in pension or similar funds from default, and, in the case of bailouts, taxpayers [micro-prudential regulation], and (2) contain and manage systemic risk [macro-prudential regulation]. All of the chapters argue that macro-prudential regulation was lacking in the current architecture of global finance. In other words, the financial system, through the procyclical nature of both its accounting and capital requirements, and the regulatory apparatus of the Basel Accords, was focused too much on individual institution risk and not systemwide risk. In other words, regulators need to focus not just on the own losses of a financial institution, but also on the cost that their failure would impose on the sy stem. It is hard to argue with this point. On page 116, chapter 4 best lays out the viewpoint of the authors: as the recent crisis has shown, indicators for future distress cannot be condensed into one single summary capital ratio, even if it very complex. Instead, we believe that regulatory intervention should be triggered by a number of relatively simple (and publicly verifiable) indicators, including measures of liquidity risk, exposures to macroeconomic shocks, and bilateral exposure to other banks or financial institutions. Following this point, all the authors in their respective essays extoll the benefits of a solvency regime for dealing with banks. This regime needs to have certain properties. First, the regulator must be powerful enough to be able to take prompt corrective action, in other words, to deal with troubled institutions prior to default.Chapter 4 in particular discusses the ability of the FDIC to take such action in dealing with its banks and argues that th is is a good model. Second, the regulator must have legal power to not only act in the case of a failure of any financial institution, but a regime needs to be set up to deal specifically with banking crises, that is, multiple failures. Third, and arguably an intractable problem, all the respective essays note that there needs to be international coordination on bankruptcy when dealing with multinational financial institutions. Another common theme across the essays, especially those of chapters 2 and 3, is the question of how to deal with liquidity. As Tirole points out, prudential regulation of liquidity can be viewed in a very similar way to that of prudential regulation of capital, that is, micro-based by protecting taxpayers, and macro-based by managing systemic risk. The authors are not particularly specific on what they would like to see, other than support for government intervention via liquidity channels and the need to consider the liquidity positions of financial inst itutions. Given their support for well-articulated simple rules, one might surmise that the authors would view the Basel III liquidity requirements (which in theory will eventually kick in later this decade) as good first steps. Another consistent theme in some of the chapters is the principle underlying the authors representation hypothesis. The basic idea is that, in regulating financial firms, regulators should take on the normal corporate governance role that one would see creditors perform for nonfinancial firms. One of the main differences between financial and nonfinancial firms is the access to the government safety net. In theory, the regulation hypothesis would solve this problem. In chapter 1 of the book, the authors describe how this hypothesis could have been used to deal with firms that either rely on wholesale funding, or that are too interconnected or generally too-big-to-fail. I believe that one could more broadly describe the representation hypothesis as the authors approach to regulating the shadow banking sector. That said, it is surprising that the book provides little discussion of shadow banking, in particular, money market funds, repo financing, securities lending, or even investment banking.Somewhat similar to the regulation that has emerged, such as the Dodd-Frank Act and Basel III, the authors primary focus is on the banking sector. I think this is a missed opportunity. In the next section, I describe three other areas I wish the book had covered in more detail. Missed Opportunity No book on the financial crisis will please every reader. This book is no different, and I thought it might be worthwhile to mention three areas where, given the authors expertise in the field of banking, I believe they missed an opportunity to inform the reader. The first is with respect to Tiroles description of how and why the financial crisis occurred. While the chapter starts with a principles-based approach, at the end of day, the chapt er provides a litany of causes but does not really choose leading candidates. The reader could have benefitted from Tiroles knowledge on the subject.While it is clear that Tirole, and the other authors, are in the camp that poorly designed regulation and insufficient implementation of regulation is the primary cause, chapter 2 does not pinpoint the market failure. It seems a necessary requirement for designing an appropriate regulatory architecture is to focus on the market failure.Therefore, it may not be a surprise that chapter 2 lays out a whole series of reforms without creating an overlay of principles that future regulation should address. In particular, chapter 1 of the book provided a historical perspective that I think could have been quite informative on how to proceed with regulatory reform. The advantage of beginning with a more pinpoint analysis of the crisis is that, once you understand how markets have failed, the nature of the solution becomes a lot clearer. There fore, not unlike the Dodd-Frank Act itself, the solutions offered in chapter 2 are a bit more heavy handed scrutiny rather than a principled regulatory response. I should say that, in defense of the book itself, however, chapters 3 and 4 are more along these lines and the suggested reforms center around macro-prudential regulation and the management of systemic risk. Having been involved in such a process through the publication of the NYU Stern books on the financial crisis, Restoring Financial Stability: How to Repair a Failed System (Acharya and Richardson 2009) and Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance (Acharya et al. 2010), I do think the authors miss an opportunity here to make a statement on the financial crisis. It seemed clear to us that, while there were a lot of symptoms of ills in the financial markets and a lot of proximate causes of the sort described in chapter 2the housing bubble, the rise in subprime lending, compen sation incentives in financial firms, a huge expansion in securitization, a big expansion of creditwhat turned a collapsing housing bubble into a devastating crisis in the financial system was the huge concentration of systemic risktail riskin the banking and shadow banking system. The second missed opportunity is that the authors do not take a lead in discussing how capital and liquidity requirements should be set, other than that these requirements should be countercyclical. While the authors provide a good analysis of what was wrong with the current system, and that this system needs to expand beyond capital requirements, it must have been clear to the authors that any new financial architecture would argue for new capital and liquidity rules. The authors have been some of the leading economic researchers in this area. There is a raging debate about both the level of and the cross-sectional variation of capital requirements. For example, Douglas Gale (2010) argues that the cas e for higher capital levels is not so clear-cut (see also Skander Van dan Heuvel 2008). Given the authors earlier work, one would imagine that the authors have a different take on this subject. The book provided the authors a perfect opportunity to address this debate head-on. From a practical point of view, capital requirements are arguably one of the more important tools used by regulators and are at the heart of the Basel Accords and the international financial regulatory regime. Lastly, while the topic of mispriced government guarantees and moral hazard is discussed in the book, I found it surprising that the topic got so little coverage. There is little analysis of what it means for our ability to regulate the financial sector when many financial institutions can finance their activities at below-market rates, which we know can lead to excessive risk. These distortions occurred not only at banks with access to FDIC insurance, but also with respect to the government sponsored (and backed) enterprises Fannie Mae and Freddie Mac and the too-big-to-fail large, complex financial institutions. And it remains a big issue. To this point, there is a study done by the Federal Reserve Bank of Richmond that found about 45 percent of all financial liabilities in 1999 fell under the U.S. safety net. They did the study a decade later and it was close to 60 percent. (See Nadezhda Malysheva and John R. Walter 2010). I do not really know what the authors view is. Do the authors believe moral hazard was a secondary issue, or, like the Dodd-Frank Act, do they believe a special bankruptcy regime can take care of the problem? Again, given the authors work on this issue, especially on the pricing of deposit insurance and market incentives, it would have been nice to provide greater elocution on the government guarantee problem. Of course, these comments are less criticisms of the authors analysis and more a wish list on my part. One interesting feature of the authors work is that their book was written prior to the enactment of significant financial regulation. The book therefore provides a somewhat unique opportunity to compare what leading economists thought was the best regulation ex ante against the actual financial regulation that got implemented, specifically the rules written into the Dodd-Frank Act and Basel III. We turn to this comparison in the next section. The Dodd-Frank Act and Basel III At one level, at least one of the authors, Tirole, should be quite happy with Dodd-Frank. The creation of (1) a consumer finance protection agency, (2) greater transparency of exposures across the system and more standardization of financial products (especially in the derivatives area), (3) the possibility at least of countercyclical capital requirements, (4) recognition of the problem of liquidity and therefore potential future regulation of liquidity, (5) some oversight albeit limited on compensation, (6) regulation of credit rating agencies, a nd (7) skin in the game in securitization markets, cover major parts of Tiroles suggested financial reforms and all of these appear within the Dodd-Frank Act. Moreover, the Dodd-Frank Act clearly emphasizes macro-prudential regulation for the first time as an important component of the financial regulatory system. The Act creates a supporting research organization within Treasury, the Office of Financial Research, to measure and provide tools for measuring systemic risk. Using this data, The Dodd-Frank Act assigns new responsibilities to a new body, the Financial Stability Oversight Council (FSOC), to identify systemically important financial institutions (SIFIs). FSOC, along with the relevant agencies, are then given the power to provide enhanced regulation of these SIFIs, such as levels of capital and liquidity necessary to withstand major shocks to asset markets. In addition, the Act also gives authority for prompt corrective action of SIFIs through the orderly liquidation aut hority which is to be run and modeled by the FDIC. All three authors should be quite pleased with the new focus on macro-prudential regulation. As Tirole writes on page 62, we note that a banks failure does not have the same consequences during a period of crisis as it does during an otherwise calm period. . .such a failure has a greater chance of having a systemic impact if other banks are simultaneously affected by a macroeconomic shock and therefore may become undercapitalized . . . this all suggests that capital requirements should be higher the more the banks failure is likely to coincide with (or be driven by) macroeconomic shocks and other banks failure. At another level though, Tirole, Dewatripont, and Rochet might be less impressed with how the Dodd-Frank Act actually manages systemic risk. The devil is in the details, and there are plenty of things in the Dodd-Frank Act that would not coincide with the authors thinking on macro-prudential regulation. Rather than prov ide a long list of issues, I will mention just a few important ones: As much as the Act argues for macro-prudential regulation, the Act is focused on the orderly liquidation of an individual institution and not the system as a whole. As all three authors would argue, there is nothing unique per se about a bankruptcy procedure for a firm; what is special is its effect on the rest of the financial sector. All three authors stress the point that, in terms of managing systemic risk, bailouts are inevitable in a crisis. The architecture of the financial system should be built around this point. I therefore believe that the authors might actually argue that parts of Dodd-Frank have actually increased systemic risk. Specifically, the Act restricts the Feds ability to deal with nonbanks in terms of its lender of last resort capabilities unless a system-wide crisis has emerged. Therefore, when the financial system is weak, temporary liquidity problems at a particular firm could trigger a f ull-blown crisis. Not surprisingly, given their research, the authors are particularly aware of the role incentives play in financial markets. Thus, I believe the authors would conclude that the Act has incentives all wrong, and arguably increases both moral hazard and systemic risk in the financial system. According to Dodd-Frank, if the system fails, and money cannot be recovered from creditors, the surviving SIFIs must make up the difference ex post. In a crisis, the prudent firms pay for the sins of others. This creates a free rider problem, a race to the bottom and greater ex ante risk taking. Moreover, when surviving SIFIs are struggling to stay afloat, they must provide capital. This is clearly pro-cyclical, further igniting the crisis. With respect to Basel III, there are certainly important changes to Basel II that are consistent with the content of this book, most notably the addition of a liquidity requirement for financial firms, a simple leverage ratio as a suppleme ntary measure to risk-based capital, and higher capital requirements overall for SIFIs. That said, the authors most likely would take a dim view of Basel III. In particular, Basel III continues the risk-weights that are tied to credit ratings both within and across asset classes, as well as the internal ratings approach that Rochet forcefully argues against in chapter 3. Remarkably, the Basel approach is still focused on the risk of individual banks as opposed to systemwide risks. The authors view that what is needed is a battery of simple and easily calculated indicators, such as exposures of banks to various macroeconomic risks, has not held the day. Instead, Basel III continues the focus of the previous Basel accords on risk-weighted capital measures of individual firms as the main indicator. Finally, as mentioned above, one of the main principles underlying the authors approach to financial regulation is based on their concept of the representation hypothesis. In the absence of market discipline, the regulator should take on the corporate governance role of debtholders. A corollary to this hypothesis is that if two financial institutions, call them bank A and shadow bank B, perform similar functions, A and B should be regulated as such. While the Dodd-Frank Act does allow for some regulation of shadow banks (if they are SIFIs), generally speaking, both Basel III and Dodd-Frank fall into the familiar trap of regulating by form rather than function. And by solely addressing the failures of banking institutions, regulators are excluding the systemically important shadow banking system that serves similar functions, such as clearing houses and money market funds. Excluding these groups of institutions makes the system vulnerable, prohibits access to emergency funding, and creates an unlevel playing field. Current regulation therefore violates the principle of the representation hypothesis put forth by the authors. Acharya, Viral V., Thomas F. Cooley, Mat thew Richardson, and Ingo Walter, ed. 2010. Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance. Hoboken, N.J.: Wiley. Acharya, Viral V., and Matthew Richardson, ed. 2009. Restoring Financial Stability: How to Repair a Failed System. Hoboken, N.J.: Wiley. Brunnermeier, Markus, Andrew Crockett, Charles Goodhart, Martin Hellwig, Avinash D. Persaud, and Hyun Shin. 2009. The Fundamental Principles of Financial Regulation. Geneva: International Center for Monetary and Banking Studies; London: Centre for Economic Policy Research. Dewatripont, Mathias, and Jean Tirole. 1984. The Prudential Regulation of Banks. Cambridge, Mass. and London: MIT Press. Gale, Douglas. 2010. Capital Regulation and Risk Sharing. International Journal of Central Banking, 6(4): 187-204. Malysheva, Nadezhda, and John R. Walter. 2010. How Large Has the Federal Financial Safety Net Become? Economic Quarterly, 96(3): 273-90. Squam Lake Group. 2010. Squam Lake Report: Fixing the Financial System. Princeton and Oxford: Princeton University Press. Van den Heuvel, Skander. 2008. The Welfare Cost of Bank Capital Requirements. Journal of Monetary Economics, 55(2): 298-320. Don’t waste time! Our writers will create an original "The Worlds Leading Economic Theorists Finance Essay" essay for you Create order