Regulatory innovations in the United States occur after financial crises. The Federal Reserve System grew out of the 1907 bank runs, and the Securities and Exchange Commission and the Commodity Futures Trading Commission were regulatory results of the Great Depression.
Recent interventions by the Fed and the Treasury have been only stopgap measures to forestall a meltdown. The costs include the depletion of both public coffers and regulatory credibility. As in previous crises, the financial sector requires a new regulatory framework.
Our current financial-crisis regulatory structure is tripartite: It includes a lender of last resort when market liquidity dries up (the Fed), a fiscal actor of last resort to redress the consequences of insolvency (the Treasury) and a market watchdog to safeguard the payment-and-brokerage system and protect investors (the SEC, in conjunction with a bevy of other federal and state institutions).
For this structure to be effective in crisis prevention, it should — but does not always — follow three general principles.
The first is incentive-based regulation. The current crisis revealed perverse incentives, including fees that were collected on mortgages without regard to the creditworthiness of borrowers. Poor corporate governance and bad pay structures led management to pursue bonuses at the expense of assessing systemic “tail” risk.
Incentives have to change. Actors should have to keep skin in the game beyond the short term — and clawbacks of bonuses based on inflated expectations must be the norm. Regulators and rating agencies must be rewarded for assessing the quality of assets and overall systemic risks, as well as for the compliance of financial institutions with rules.
The second principle is to avoid divided regulation of the same firm across different financial operations. Unfortunately, American regulation is divided between the federal and state governments and overlapping regulatory bodies. The Fed and the Office of the Comptroller of the Currency at the Treasury regulate banks, the SEC regulates investment banks (which should be the Fed’s purview) and no one regulates hedge funds. The states regulate insurance, which is why AIG’s rogue credit-default-swap shop, headquartered in London, was not regulated.
The third principle of financial-crisis preparation is prudential regulation. The Basel II Accord institutionalized a new approach to risk by requiring banks to provide their own models of risk measurement and risk-weighted capital. The intention was to lower the costs of excessive capital reserves. Instead, Basel II introduced complexity that rendered risks opaque to regulators. Thus, we saw credit-default swaps grow into a multi-trillion-dollar market conducted through private contracts. Such trades must be moved to centralized clearinghouses, because otherwise regulators will have no knowledge of global exposure.
These principles are necessary for prevention, but they are as insufficient for resolving the next crisis as the Maginot Line was for defeating the blitzkrieg. In this crisis, regulators hoped that a leak in one module of the market would not spill into the entire market. Unfortunately, the hallmark feature of modern financial crises is that modularity dissolves. All the markets behaved erratically at once, and the problem became global.
That is why a regulator of regulators — call it the Crisis Resolution Board — must monitor and respond to systemic risks. Absent such a supra-regulator, the tripartite separation of powers among the Fed, the Treasury and regulators can become a catfight on a burning deck. And it does: UK chancellor of the exchequer Alistair Darling’s public fury at the Bank of England’s proposal to inject capital into banks mirrored behind-the-curtain negotiations in the United States.
The Crisis Resolution Board cannot be merely an honorary body. Effective intervention will require social capital, because solving crises requires the personal knowledge and influence of the players. The Crisis Resolution Board should have an oversight committee, which would include the chiefs of the Treasury, the Fed and the regulatory agencies, as well as industry and investor representatives. In addition, the board must have knowledge of global exposure and systemic risk provided by a research staff that continually tests its instruments against the dynamic evolution of markets.
Concretely, what would the board do? First, it would have power to monitor the exposure of all financial institutions and markets and to issue early warning signals. This is hardly a radical idea. The IMF plays a similar role at the global level in monitoring national reserves. Second, like any good fire brigade, which has a deep respect for plumbing, when things get hot the board will ensure that the financial markets’ plumbing is functioning. Markets depend on brokerage, exchanges and settlement. That’s their plumbing, and that’s also the key to systemic risk.
The current crisis shows that none of the tripartite system’s players are systematically charting that risk. The Fed and the Treasury understood that Bear Stearns provided critical brokerage services to hedge funds and that AIG was the pivotal player guaranteeing collateral behind the enormous credit-default-swap system. That part of the plumbing was salvaged. The Treasury allowed Lehman’s bankruptcy to destroy the value of the credit-default swaps that Lehman had sold to guarantee the bonds it underwrote, and in the process, the corporate bond market was gravely impaired. When those pipes froze, so did the financial system.
Regulatory reform should seek to distinguish between crisis prevention and crisis resolution. Prevention relies upon a tripartite structure and clear rules of accountability. Crisis resolution demands an integrated approach to systemic risk. Both structures are required, but to date no country has designed such a system. This is the time to do so.
Patrick Bolton is the Barbara and David Zalaznick Professor of Business in the Finance and Economics Division at Columbia Business School; Bruce Kogut is the Sanford C. Bernstein & Co. Professor of Leadership and Ethics in the Management Division at Columbia Business School and the director of the Sanford C. Bernstein & Co. Center for Leadership and Ethics; and
Tano Santos is Franklin Pitcher Johnson Jr. Professor of Finance and Economics at Columbia Business School.
This piece is adapted from a proposal in the report on the December 2008 conference “Preventing the Next Financial Crisis,” presented by the Sanford C. Bernstein & Co. Center for Leadership and Ethics. A version of the proposal also appeared on Forbes.com.
Patrick Bolton is the David Zalaznick Professor of Business. He joined Columbia Business School in July 2005. He received his PhD from the London School of Economics in 1986 and holds a BA in economics from the University of Cambridge and a BA in political science from the Institut d'Etudes Politiques de Paris. He began his career as an assistant professor at the University of California at...
Bruce Kogut is the Sanford C. Bernstein & Co. Professor of Leadership and Ethics and Director of the Sanford C. Bernstein Center for Leadership and Ethics at Columbia Business School. He teaches the core courses in strategy and in governance and an elective on "The Future of Finance" for the MBAs and EMBA and has taught in executive programs in the US...
Professor Santos' research focuses on two distinct areas. A first interest is the field of asset pricing with a particular emphasis on theoretical and empirical models that can account for the predictability of returns, both in the time series and the cross section. A second interest of Professor Santos is applied economic theory, specifically, the economics of financial innovations as well as theory of...