policy recommended for the crisis
Separation of Commercial and Investment Banking Separation of commercial and investment banking is one of the most common proposals from economists. Part of the idea is that regulators are very focused on depositor protection and that if depositors can be isolated from trading risks, securities activities can be left less regulated. “Too big to fail” problems are reduced and the costs of depositor insurance is lowered. A more radical version of the same proposal would require 100% reserve backed depository institutions.
Compensation Limits Compensation limits are proposed to reduce incentives to take excessive risk and align shareholders with employee interests. Yet legislative proposals entirely miss the point that the “principal-agent” problem at the core of bonuses paid for poor performance arises because of inadequate information, difficulty framing suitable contracts and/ or the high costs of moving to structures with superior incentives. Compensation limits will likely only “work” to reduce incomes in circumstances where they are not needed – where performance attribution is easy and akin to a sales
Pouring oil on a slope – proposals for regulatory change
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Best Practice
Source: World Economic Forum
It follows that many of the proposals for change to the financial system are flawed. Rather than help improve management of risk, they pour oil on the slope.
There are two problems with these proposals. First, it is practically at odds with recent experience that saw “universal” banks as the survivors and largely eliminated big securities companies. Second, and more importantly, the distinction that might once have been meaningful is now moot. Deposit products can take many forms and depositors have shown a desire for yield that will always see them allocate funds away from a narrow depository institution. It is not at all clear why depositors should be protected from securities trading risks, but not credit risks in traditional lending. Indeed in practice, interest rate mismatchrisks have often been as big an issue for bank profitability as credit. In modern financial markets, trading is also an important part of almost all commercial banks. Foreign exchange and interest rate risk management products, as well as simple debt securities like commercial paper, are an integral part of operations. It is not possible to draw a line between commercial and investment banking activities.
My hypothesis would be that many of the failures by firms that contributed to the crisis are the result of the massive structure of legislation, regulation, taxation, supervision, consumer protection and competing non market provision of financial services that make markets less effective than they could be in the financial sector. Asking what regulations we need to reduce the risk of financial crisis is the wrong question. So is asking how we should redesign institutions to reduce risk. The right issue is how to eliminate transaction costs in the financial sector that impair the market allocation of resources which make more pervasive “principalagent” problems and increase moral hazard.
The moves we make on government policy, market process and entrepreneurial innovation shape the future.
commission (e.g., equities broking or advisory businesses). This would drive those activities to boutiques. Limiting compensation will face the same problem as managers of financial institutions where the time frame of profitability is long, capital allocation difficult to determine and individual contributions hard to assess. Promoting rather than limiting markets is a better solution to that problem. Eliminating the “Shadow Financial System” Eliminating the “shadow financial system” of structures that have been largely “off balance sheet” and domiciled in offshore jurisdictions is proposed to increase regulatory scrutiny and transparency. However, the jurisdictional competition provided by the “shadow” system has been crucial to reducing transaction costs – it has allowed