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About Reason, Rationale & Regulation Richard J. Herring, Jacob Safra Professor of International Banking at the Wharton School of the University of Pennsylvania, sheds some light on the current progress of banking regulation reforms, as we emerge from the most recent financial crisis. Prof. Herring offers insights into the underlying complexities of our financial system that hinder the progress of reforms, and stresses the importance of international cooperation for successful regulation. In what ways have your ideas regarding financial regulation changed as a result of the recession? They have changed in a major and in a minor way. The former is that systemic risk is no longer just a phenomenon of commercial banks. I think the entire profession, and particularly the Federal Reserve board, has always assumed that this was true. Our favorable experience with the bankruptcy of Drexel-Burnham in which the stock market actually rose when it failed reinforced this belief. However, investment banks have changed in ways that have made them clearly systemic. The boundary may even go beyond investment banks. We simply do not have the tools to deal with such institutions and it is not yet clear that we will get them from the legislation. Moreover, we have found that our tools for dealing with systemically important commercial banks are also inadequate because of the incredible corporate complexity they have developed. The small thing that surprised me was the extent to which the large investment banks had grown dependent on repos or collateralized short-term borrowing. I had always thought that one of the safest ways to borrow in the short term was repos or collateralized short-term lending,

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because you could divorce your need for funds from any potential lender’s concern about your solvency. Yet the extent to which the large investment banks relied on this kind of funding surprised me: repos grew to 60 percent of demand deposits. If it had been known – and somebody from the government should have been tracking it – what was happening to leverage, maturity mismatch, and asset quality among the systemically important institutions – this crisis should not have happened. There is therefore a huge failure in regulation. Moreover, once the crisis started, they were totally unprepared to deal with it. So, while it was true that they had to fix the financial sector first, but they took such a long time to make the correct diagnosis that it wasted an enormous amount of financial resources and inevitably, gave rise to really painful contractions in the real sector. As early as September 2007, it should have been obvious that we had a solvency problem in our major banks. And yet, for a whole year, with the minor exception of the bailout of Bear Stearns, which was depicted as a liquidity problem, the government was concerned mainly with pumping liquidity into the system, even though it was clear that this was not working. Banks were choosing to hold excess reserves when they

International Business Review - Spring 2010  

The Spring 2010 edition of the IBR.

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