New Financial Regulation Should Prevent AIG-like Follies without Hampering Economic Growth

With governments hard at work on a new financial regulatory framework, what can they do to prevent future financial black holes without blocking economic growth? New regulation and oversight of credit default swaps and other over-the-counter derivatives market is being contemplated. Unfortunately, given that regulating over-the-counter exchanges between private parties is highly complicated, firms will find ways around the regulatory fence, which might lead to future blowups and large scale bailouts.

Instead of trying to fix a broken market, it is preferable to have new regulation that is simple and enforceable. First, financial derivatives should only be traded through public exchanges, not over-the-counter, so that complete information on open positions is available to the regulator and liquidity is enhanced. Second, all large financial institutions should fund themselves only with equity, deposits and standard debt contracts so that all their liabilities are clearly seen in their balance sheets. Such firms should not be allowed to sell insurance-like derivatives. Since these simple rules will apply to all financial firms, including banks, hedge funds, and insurance companies, they will avoid future black holes in the financial universe by preventing as yet unknown too-big-to-failfirms from selling insurance-like securities without restraint. However, they will not kill the natural risk-taking process that accompanies the resumption of sustainable economic growth.

There are three reasons why these rules are necessary for the regulatory framework to be effective. First, future systemic bailout guarantees—either explicit or implicit—cannot be eliminated by decree because they are not well-calculated choices made by policymakers, but emergency measures in order to avoid a perceived systemic damage and out of fear of potential contagion. Second, if regulatory rules are not simple and easy to verify, market participants will find ways to circumvent the regulatory fences and take advantage of the systemic bailout guarantees. Third, regulatory limits to leverage without restrictions on the use of derivatives will likely be ineffective.

Since systemic bailout guarantees are inevitable and it is impossible to erect a hermetic fence around financial institutions, the regulatory framework should ensure that no too-big-to-fail firm can issue insurance-like liabilities such as credit default swaps (CDSs) whose potential repayments are hidden off the balance sheet. These types of instruments make it very easy for firms to hide the extent of their potential obligations as well as its concentration, to attain huge leverage.

The efficiency gains of financial derivatives rely on the assumption that the increase in leverage occurs without a loss in the discipline that comes from the requirement that borrowers must risk their own equity. This discipline has traditionally come about by limiting external finance to standard debt contracts, under which borrowers must repay in every period to avoid bankruptcy. This might be too stringent a disciplining device, but it is robust: you cannot fool the regulator and the market so easily.

Such discipline is missing in an anything-goes regime under which big financial firms can issue any type of liability, like the over-the-counter sale of CDSs or options that promise a huge payout in case of a disaster. From the issuer’s perspective, it might be profitable to sell these derivatives because very little equity needs to be put as collateral, so leverage can be very large. From the buyer’s perspective, having such insurance on the books reduces not only risk, but might also reduce the regulatory capital requirements which in turn allows for greater leverage. The problem is that if the disaster actually occurs, the issuer might face bankruptcy.

Some might counter that because players in financial markets are sophisticated, they would not fall for this trap if it were not a profitable deal in expected terms. Not so fast. First, when many issuers are interconnected and have issued  liabilities that load on the very same type of risk, as we have seen in the recent mortgage-based debacle, a bailout will be granted in case of disaster, and so the buyers of such insurance instruments will be made whole. We have just witnessed this trick: out of AIG’s $173 billion bailout by the US government, about $120 billion were used to make financial institutions and local governments whole. Second, often the bonuses of managers on both sides of the deal depend on the short-term profits generated by these transactions. Meanwhile, it might take a while before a disaster actually occurs.

Financial derivatives such as CDSs play an important role, but should only be traded through public exchanges, not over-the-counter between two private parties. Under the former, the positions of all participants are transparent to the regulator, strict collateral requirements are imposed daily through margin calls, and traded instruments are standardized, which enhances liquidity.

In sum, in the presence of bailout guarantees, a regulatory regime that allows for the issuance of just any type of financial securities might have the unintended consequence of creating financial black holes. Financial derivatives such as CDSs designed to reduce uncertainty at the individual firm level have made possible states of the world under which the failure of one financial institution can trigger the default of many others

The above does not imply that the regulatory framework should have as an objective the prevention of all potential financial crises. The degree of financial repression and government intervention that would be necessary would drastically reduce risk-taking and growth. Our research shows that over the last five decades countries that have liberalized financially are the ones that have grown faster, even though they have experienced rare crises.

What we need instead is a regulatory regime that promotes economic growth by keeping the upside of financial liberalization, but maintaining credit market discipline and preventing the excessive leverage observed in an anything-goes world. The framework must be simple and any breaches should be easily verifiable by the regulator and the market. The two rules we are proposing satisfy these conditions:  they will lead to a natural limit on excessive leverage but not on risk-taking.

Romain Ranciere (Paris School of Economics) and Aaron Tornell (UCLA)

One Response to "New Financial Regulation Should Prevent AIG-like Follies without Hampering Economic Growth"

  1. Anonymous   April 9, 2009 at 2:56 pm

    While everyone sweats about AIG, there’s a bigger scandal going on: high school dropouts cost the American Public $100 million a year. Our current financial crisis is one of class not of “black holes”. We need to do something about it.