Market based financial system vs bank based financial regulation

I was reading papers presented at Kansas City Fed Symposium 2008.  Three papers presented in this Symposium are epics (above 100 pages), and the other three are around 40-50 pages. Obviously, I picked the latter.

I read this paper by Anil Kashyap, Jeremy Stein and Raghu Rajan and other one by Adrias Tobin and Hyun Song Shin . Rajan et al suggest a new measure to help banks manage risks better. They say there are two things which stand out w.r.t banks in this crisis:

1) Banks continue to have substantial amount of mortgage backed securities (MBS) on their balance sheets despite having the option to securitise

2) banks financed these assets with short -term market borrowing.

Now as house prices fell, so did value and risks of MBS. As Banks sold these assets it led to fire sales depressing prices further. And as assetpositionworsened banks found it difficult to raise capital/get short term borrowing etc….This led to problems for all.

Rajan et alsay theobvious solutions is to raise capitalstandards but this has problems and doesn’t address main causes for all the problem. The main problem is banks don’t like equity capital as it is expensive.  Moreover, investors prefer to give debt as they worry that any bad decisions by managers could lead to wipe out of equitycapital.

So by asking banks to have more equity capital might be difficult to implement at the first place. But this way that capital lies inefficiently on the balance sheet which no one likes and if they again use it as they used it, we are still open to the earlier problem. Another point is that Banks were thought to be well capitalised as the crisis struck. So what is the way out?

Their main idea is that there should be a insurance market. The investors buy an insurance policy against a bank and monies are invested in a lockbox(invested in treasuries). If there is a problem with the bank the money goes to the bank and if not the money along with the interest goes back to the insurer.  JRV compares the concept to a catastrophe bond. Read the paper for more details.

A good idea but we already have credit derivative markets which also work on the same idea. Only thing is that monies are not invested in a lockbox and instead we have a market where swap rates are readily available and traded. Moreover, with a highly interconnected marketwhat is needed is a solution that applies to other financial firms as well. For instance in this crisis we have seen problems with Bear Stearns (an I-bank) and Freddie/Fannie (Housing mortgage companies). So we need to look at the problem in a holistic manner.

In the other paper Shin et al show the importance of looking at other market intermediaries (they call them broker dealers).  

In a market-based financial system, banking and capital market developments are inseparable. We document evidence that balance sheets of market-based financialintermediariesprovide a window on the transmission of monetary policy through capital market conditions. Short-term interest rates are determinants of the cost of leverage and are found to be important in influencing the size of financial intermediary ba lance sheets. However, except for periods of crises, higher balance-sheet growth tends to be followed by lower interest rates, and slower balance-sheet growth isfollowed by higher interest rates. This suggests that consideration might be given to a monetary policy that anticipates the potentialdisorderlyunwinding of leverage. In this sense, monetary policy and financial stability policies are closely linked.

This is pretty much what we see in the ongoing crisis. The effect is on the entire financial system. The authors show how important market intermediaries have become and their supply of credit to markets has increased post securitization. Though broker dealer assets are still 1/3rd of bank former have grown at a much faster pace. The authors show how monetary policy has a big impact on these intermediariesandposes problems for financial stability because of leverage linkages.  Read the paper for details.

This brings me to the title of the post. I realise financial system has increasingly become marketbasedbut regulation is still centred on banks.   I mean regulation to increase capital, Rajan et al’s solution etc. For other market firms we ususally have regulation like disclosures, annualreportingetc. Not as stringent prudential supervision and regulation as we see in the case of Banks. (For a primer on Bank Based vs Market Based system see this)

We saw in LTCMcasethat a non-regulated firm could pose significant challenges to the entire financial system. That time also Fed had to intervene. This time Fed had to intervene and privide support to Fannie/Freddie and Bear Stearns, both outside Fed ambit.

It is not just markets but activities of financialfirmsthat are getting integrated as well. What is needed is a rethink on financial regulation and make it more market based (focus will still be on banks). THis is exactly what Robert Solow said as well:

Could we redesign the mechanism to achieve most of the benefits of a broader supply of mortgage capital while sharply limiting the scope for predation and instability? This question calls for serious thought….Still, it is worth noting–….that when the Federal Reserve recently proposed some fairly anodyne improvements in the regulation of mortgage lending, the industry instantly opposed them as incipient socialism, and claimed implausibly that even the smallest regulatory safeguards would dry up the supply of loan.

 

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