Academic journal article Chicago Fed Letter

Reforming Financial Regulation-A Conference Summary

Academic journal article Chicago Fed Letter

Reforming Financial Regulation-A Conference Summary

Article excerpt

The Chicago Fed's 45th annual Conference on Bank Structure and Competition, which took place May 6-8, 2009, brought together industry personnel, regulators, and academics to discuss the recent financial crisis and financial regulatory reform, among other issues.

This article summarizes two key panels from last year's Conference on Bank Structure and Competition - Reforming Financial Regulation and Responding to the Financial Crisis: Lessons Learned.1

Reforming Financial Regulation

The theme panel for the conference was moderated by Daniel G. Sullivan, Federal Reserve Bank of Chicago. It featured Raghuram G. Rajan, University of Chicago; Diane Casey-Landry, American Bankers Association (ABA) ; Robert Kuttner, American Prospect; Hal S. Scott, Harvard Law School; and Thomas H. Stanton, Johns Hopkins University. There is almost universal agreement that the regulatory system did not function optimally during the crisis, Sullivan noted. Yet, no such consensus exists on what aspects of the system were flawed or on what needs to change.

Rajan concentrated on the means to alleviate the problems associated with financial institutions deemed too-systemicto-fail (TSTF). He purposely avoided using the more common term too-big-tofail because size alone does not dictate whether a firm is systemically important; the structure of the firm must also be considered. Rajan evaluated three methods to address the TSTF problem: prevent institutions from becoming systemically important; create additional private sector buffers to reduce the likelihood of failure; and make it easier for regulatory authorities to "fail" (resolve) these institutions.

Regulators could take a rather blunt approach, i.e., limit institutions from expanding beyond a certain size and/ or limit their financial activities. One concern about this approach, said Rajan, is that regulators would have to be given substantial discretion in determining the appropriate structure of firms. For instance, the size threshold could vary significantly for different types of institutions. Efficiency could be another concern. Rajan noted that "some institutions get large not through unwise acquisitions, but through organic growth based on superior efficiency." Setting limits on product mixes could also be difficult. For example, it would be difficult to distinguish speculative proprietary trading from hedging activities. Rajan argued that if regulators were allowed such discretion, financial institutions would attempt to evade the regulations, leading to less transparency.

Rajan also pointed out problems with subjecting systemically important institutions to higher regulatory capital requirements to cushion them against losses. If, as in the past, the market requires financial intermediaries to hold less capital than regulatory requirements dictate, there is an incentive to shift activities to unregulated and potentially riskier operations, such as structured investment vehicles (SIVs) and conduits. Also, the higher capital requirements could increase the cost of intermediation to the real economy, resulting in a drag on economic activity.

As an alternative, Rajan argued that policymakers should seriously consider implementing contingent capital arrangements, such as contingent convertible debt2 or fail-safe insurance.3 With convertible debt, financial institutions would issue reverse convertible bonds to private investors. These debt instruments would convert to equity when two conditions are satisfied: the system goes into a crisis as declared by a supervisory institution and the bank's capital ratio falls below some predetermined level. When the bonds convert, the capital position of the bank could be bolstered and the need for bankruptcy or a costly bailout could be avoided. These instruments would also provide an incentive for firms to raise new equity in order to avoid the dilution of existing shares from the forced conversion.

Under a fail-safe insurance plan, Rajan said, systemically important financial institutions would buy fully collateralized insurance policies from unlevered investors. …

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