How to create better financial regulation & institutions
The crisis threatens to lead to a serious and long recession in developed countries and globally. To overcome the failures of both markets and policy that have been major factors contributing to the crisis, two key principles of regulation need to be followed: comprehensiveness and counter-cyclicality.
Regulation has to be comprehensive so that the domain of the regulator will be the same as the domain of the market; otherwise, regulatory arbitrage is inevitable. Off-balance sheet instruments, like structured-investment vehicles, should be brought onto the balance sheets, and on-site inspection of banks and other financial institutions should be expanded. Comprehensive regulation should relate both to liquidity and solvency.
Counter-cyclical bank regulation can be easily introduced, either through banks' provisions or via their capital. This both discourages excessive lending in booms and strengthens the banks for bad times. An alternative approach for counter-cyclical bank regulation is through capital. This provides a clear and simple rule for introducing counter-cyclicality into the regulation of banks. The compensation of bankers and other market actors has to be regulated.
In terms of new institutional arrangements for regulation, there are necessary changes at both national and international levels. A financial products safety commission could evaluate products, especially those being produced and invested in by regulated entities. Such a commission would determine whether individual products provided significant risk mitigation benefits of the kind purported by the product.