Bloomberg View asked scholars to identify the most important development or new research of the last year.
As 2014 begins, we should avoid both a hangover from a party of financial regulation and harsh cures.
Complacency about aggregate risk, excessive and opaque leverage, fragile funding structures and too-big-to-fail financial institutions left us poorly prepared for the financial crisis. And, our regulatory focus on the health of individual institutions left us vulnerable to contagion across the financial system.
We learned that, in cleaning up the crisis, both monetary policy (lender of last resort) and fiscal policy (bank recapitalization) are important. But regulatory reform has been much less encouraging -- focusing on dogs that didn’t bark (the ban on proprietary trading by large banks), virtually ignoring dogs that did bark (the government-sponsored enterprises), and putting forward rules with potentially adverse consequences (the designation of Systemically Important Financial Institutions and substantially higher capital requirements for banks).
Two big questions arise for 2014: What should we do about “big banks”? And by how much should we increase bank capital requirements as a vaccine against the next crisis?
On the first, the treatment may be worse than the supposed disease. While I am sympathetic to proposals that eliminate too-big-to-fail, any alternative is less desirable; just “breaking up” big banks doesn’t eliminate problems of correlation in risks in the financial system. And “utility regulation” of big banks runs the risk of dulling financial innovation.
On the second, greatly higher capital requirements can have unpleasant side effects. Much higher levels of capital reduce lending to borrowers with few non-bank alternatives. And high bank capital requirements shifts activity to shadow banking, with its attendant risks.
Finally, a memo to the White House and Congress: Rather than join the tough gym of harsher regulation in 2014, let’s try good regulatory habits next year.