A lesson to learn

"Cycle-proof regulation"

This article written by a former IMF economist details his idea of a possible "non-band aid" solution. He basically comes up with an idea to keep banks capable of producing the necessary cash when times are good, so that they can use it when the economy turns bad. The author comments that regulation usually is allowed to progress when times are bad and public sentiment is in the regulators favor. This idea needs to be implemented by more than just banks. The public could use this dose of medicine, too. What's interesting is who will actually put this into practice. My bet is that the financial sector will put on a face for the public to show sorrow and a "real change of heart," and may even make some actual changes here and there. The public on the other hand will make the more significant and long lasting change to prevent a crisis again. I could be wrong. Maybe the banks will actually figure out a way to cash in on public savings.


Dr. Tufte said...

Rajam is another Nobel Prize medium-lister. Always read what he says!

I think his point is fascinating: totally obvious, in retrospect.

Best of all, he has practical solutions.

First, he wants contingengy-convertible-debt. Most debt that is convertible to equity is managed at the discretion of the firm. Rajan calls for debt that converts involuntarily when the economy turns sour. This solves the problem of regulators wanting financial institutions to show that they can raise new equity when markets are bad.

Second (and this one is awesome), he wants them all to file and maintain a shelf-bankruptcy. This means that managers have a plan on the books, that can be called into play by regulators, about how to dissolve the company. Gosh ... do you think this would help keep management on the straight and narrow?

Joe said...

Rajam's ideas seem viable but extremely difficult to implement in the current political climate. Yet, while it is two years after his article, the suggestions made seem just as applicable today.

The idea of pooling risk by requiring banks to purchase what amounts to "liquidity insurance" is a good one. Recall he does not advocate purchasing the policy from a pool of banks, similar to a state Guaranty Association for life insurance carriers. Purchasing a policy from another industry would provide more risk diversification which would provide more stability. But who would have the ability to take on that much risk? Unlike purchasing reinsurance in which a company sells a portion of their "block of business" to another in hopes of diversifying risk, this would require a source with substantial financial stability. I know he mentions the government as well as other sources but the government may be the only initial and viable option available.

Now that we are approaching another election cycle, political will seems weak and rhetoric remains high. I suppose the government will have to first learn how to set a budget—for the year—before the year is over— before we can attempt thoughtful solutions such as Rajam’s.

Dr. Tufte said...

It's interesting that you went back to this one Joe.

I think these are still good ideas, but 2.5 years have shown that there isn't a lot of political will to deal with systematic solvency issues.