PRAGOTI

The Obama administration in the US has proposed new regulations for banking institutions. The poposal is twofold:

1. Stop commercial banks from trading on their own accounts, running hedge funds etc. Since the deposits of banks are protected by government-backed deposit insurance, allowing them to undertake risky activities creates the moral hazard that they will take excessive risks in the knowledge that a bail out will be at hand if they lose. This is in the spirit of the Depression-era Glass-Steagall Act.

2. Stop financial institutions from growing too large, in the hope that no one will be "too big to fail".

These proposals are welcome to the extent that they are part of a departure from the Greenspan-era belief that the best regulation for the financial sector is self-regulation.

However, in terms of actual effectiveness these proposals are unlikely to have a large impact. Financial firms will find it easy to escape (1) by stopping being commercial banks in legal form while issuing liabilities that look and act for all practical purposes like deposits. Even though these liabilities would not have explicit insurance from the government, the government will find it difficult to let them fail if these liabilities are widely held. Think of the Indian government's rescue of the UTI. Anticipation of such rescues will lead to the same kind of risky behaviour that explicit insurance would have.

(2) too would not be very effective by itself. The problem in the current crisis was not "too big to fail" by itself. The real problem was the opaqueness of the dependence between financial institutions which made it hard for anyone to figure out clearly who owed what to whom in the middle of the meltdown. By imposing size restrictions the government would only be providing incentives for firms to consolidate virtually by building more of these opaque interlinkages.

While no one knows for sure how to prevent the next crisis, and while regulation is always an arms race between the regulator and the regulated, it seems that two things at the minimum seem required in the light of the present crisis. First, we need some kind of control on "financial innovation" to prevent overcomplex contracts whose opacity costs outweigh their risk-sharing benefits. Second, we need some kind of regulation on incentives for managers of financial institutions that exposes them to a larger part of the downside effects of their decisions. Crafting regulations on these lines that would apply to the entire financial system would also give the regulators a head-start in the arms race since the regulated would not be able to escape by repackaging themselves in new legal forms while continuing to perform the same old functions.