Financial Regulation Going Forward*Franklin Allen
University of Pennsylvania
allenf@wharton.upenn.edu
andElena Carletti
European University Institute
Elena.Carletti@EUI.eu

May 6, 2010

Abstract
The financial sector is heavily regulated in order to prevent financial crises. The recent
crisis showed how ineffective this regulation and other types of government intervention
were in achieving this aim. We argue that the crisis was primarily caused by housing
price bubbles. These occurred because of too loose monetary policies and the easy
availability of credit resulting from the build up of large foreign exchange reserves by
Asian central banks. A number of regulatory reforms are suggested. It is also argued that
central banks need to have more checks and balances. Finally, the international financial
architecture needs to be changed so that Asian countries do not feel the need toaccumulate large foreign exchange reserves.

*

Prepared for the 2010 International Conference on The Future of Central Banking under Globalization, tobe held May 26 - 27, 2010 at the Institute for Monetary and Economic Studies, Bank of Japan.

1. Introduction
In the majority of countries the financial sector is the most regulated part of theeconomy. The primary purpose of this regulation is to prevent financial crises. The
Crisis of 2007-09 has shown the inability of current regulation to achieve this goal. The
Basel Agreements provide a good illustration of the problem. Despite the large amountof resources devoted to designing and implementing these in the last two decades, and theextensive international cooperation involved, these agreements did very little to preventthe crisis or lessen its effects. The problem is that unlike other areas of regulation there isno coherent theoretical framework underpinning the measures. In contrast, withenvironmental regulation, for example, it is widely agreed that the problem is a missing
market. Polluters do not need to compensate anybody for the damage that they cause. As
a result it is necessary for the government to step in and regulate emissions and so forth.
Similarly, with antitrust regulation everybody agrees the problem that is being solved is alack of competition.
But with financial regulation, what are the market failures that justify
intervention? The Basel Agreements do not provide an answer to this question. In fact
there is no wide agreement among academics, practitioners or regulators on this issue.
One view is that financial crises are mainly due to panics as argued by Friedman and
Schwarz (1963) for the U.S. in the nineteenth and early twentieth centuries. As theseminal theoretical contributions by Bryant (1980) and Diamond and Dybvig (1983) haveshown, if everybody believes there will be a panic, then the panic is self-fulfilling.
Everybody will find it worthwhile to take their money out of the banking system.

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However, if everybody believes there will be no panic they will keep their money in.
Another view is that crises are caused by the business cycle. If people expect a recession
then they will withdraw their money from the banking system in anticipation of loans
going sour and the banks being unable to repay them. Gorton (1988) and Calomiris andGorton (1991) have provided evidence for this view using data from the U.S. in the latenineteenth and early twentieth centuries. A third view is that financial contagion is afundamental problem and provides a rationale for government intervention. If one
financial institution fails then other institutions holding claims on it may also fail. Allenand Gale (2007) consider these and a number of other possible causes of financial crises.
The current structure of banking regulation is a patchwork of measures resulting fromthe historical sequence of events rather than the implementation of a clear regulatory design.
In the Great Depression, the economic situation was so bad that governments adopted awhole range of measures to stop any kind of problem. In the U.S., legislators passed the
Glass-Steagall Act separating investment and commercial banking, they founded the
Securities and Exchange Commission (SEC), they put in place all the SEC Acts,1 and thefinancial system became heavily regulated. In other countries, regulation was also increased
and in some such as France, financial institutions were nationalized. This regulation andgovernment ownership was successful in terms of stopping banking crises. From 1945 until
1971, there were no banking crises, except for one in Brazil in 1962 that occurred together

1

The seven acts are: The Securities Act of 1933; The Securities Exchange Act of 1934; The Public Utility
Holding Act of 1935; The 1939 Trust Indenture Act of 1939; The Investment Company Act of 1940; The
Investment Advisers Act of 1940; The Securities Investor Protection Act of 1970.

2

with a currency crisis (see Bordo et al. (2001)). So it is possible to stop crises by stopping
financial institutions from taking risks.
However, the alternative to the private sector taking decisions about risks and theallocation of resources is essentially that the government determines who gets credit. Thiswas done in different ways. In countries like France with nationalized banks, the government
directly made decisions. In the U.S., the government introduced so many regulations thatbanks couldn't take many risks and so low risk industries were allocated credit. As a result,the financial system stopped fulfilling its basic purpose of allocating resources where they
are needed. In the 1970s it became clearer how inefficient this was and financial
liberalization started in many countries. However, this led to a revival of crises. Since then,there have been crises all around the world (see, e.g., Boyd, De Nicolo, and Loukoianova(2009)). This historical evolution has led to a patchwork of regulations designed to stop
particular problems rather than a well thought out way of reversing market failures in thefinancial system.
In this paper we start in Section 2 by discussing the origins of the recent crisis andargue that the general pattern is similar to other major crises. As Herring and Wachter(2003) and Reinhart and Rogoff (2009) document, crises are usually the result of asset
price bubbles, particularly in residential and commercial property. When these bubbles
burst, the real economy and the financial sector are adversely affected. The current crisis
provides a good example of this. We argue that the property bubbles in the U.S., Spain,
Ireland, and elsewhere were the result of two main factors. The first was that central
banks set interest rates that were too low during the period 2003-2004 at a time when3

house prices were already rising quite fast. This set off the bubbles. The second was that
global imbalances, and in particular the acquisition of reserves by Asian central banks
after the Asian Crisis of 1997 led to the easy availability of funds.
In Section 3 we discuss how regulation and government intervention in thefinancial system should be reformed going forward. Capital regulation is the major form
regulation used internationally and this is discussed at length. It is suggested that interest
deductibility of debt for the corporate income tax should be eliminated as this would
largely eliminate the social cost of requiring high equity buffers. We argue that “Too big
to fail” should not mean “Too big to liquidate”. Ways of eliminating the problems posedby large complex cross-border financial institutions are proposed.
Financial regulation is only one part of the intervention that is required to prevent
crises and ameliorate their effects should they occur. Section 4 discusses the role ofcentral banks in causing the crisis through low interest rate policies and the reforms
necessary to prevent this going forward. Central banks need to be much more focused oncontrolling asset price inflation. In addition their design needs to be changed to ensurethat there are more checks and balances.
Section 5 discusses how the international financial architecture needs to beredesigned to reduce the desire of Asian central banks to hold large reserves. This will
reduce the easy availability of funds that together with low interest rates played such alarge role in creating the bubble.
Finally, Section 6 concludes.

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2. The origins of the recent crisis
Despite its severity and its ample effects, the recent crisis is similar to past crises
in many dimensions. There have been crises in many other parts of the world in the lastfew decades. Many of these were in emerging or middle income countries such as
Argentina, Mexico, and Turkey, but many were in higher income countries. The crises inJapan, Scandinavia, and Asia in the 1990’s stand out as being particularly severe.
Reinhart and Rogoff (2009) document the effects of banking crises using an extensive
data set of high and middle-to-low income countries over a long period of time. They findthat systemic banking crises are typically preceded by credit booms and asset pricebubbles. This is consistent with Herring and Wachter (2003) who show that manyfinancial crises are the result of bubbles in real estate markets. In addition, Reinhart andRogoff find that crises result, on average, in a 35% real drop in housing prices spreadover a period of 6 years. Equity prices fall 55% over 3 ½ years. Output falls by 9% over
two years, while unemployment rises 7% over a period of 4 years. Central government
debt rises 86% compared to its pre-crisis level. These averages are not that dissimilarfrom what happened in many countries in the recent crisis.
This evidence from a wide array of financial crises suggests that the problems with
subprime mortgages that marked start of the current crisis in August of 2007 were a
symptom of the bursting of the property bubble rather than the cause of the crisis as many
people initially believed. No doubt they considerably exacerbated the crisis, though. It was
widely argued that what had happened was that the way the mortgage industry worked hadchanged significantly over the years. Traditionally, banks would raise funds, screen

5borrowers, and then lend out the money to those approved. If the borrowers defaulted, thebanks would bear the losses. This system provided good incentives for banks to carefully
assess the creditworthiness of borrowers. Over time, that process changed and incentives
were altered. Instead of banks originating mortgages and holding on to them, brokers andalso some banks started originating them and selling them to be securitized. The quality ofthe securitized mortgages was certified by the ratings agencies. This process is termed the“originate to distribute model.” According to this mortgage incentives view of the crisis, thewhole procedure for checking the quality of the borrowers, and the mortgages underlying thesecuritizations broke down. This analysis suggested that it would be fairly simple to solve
the crisis and stop it from reoccurring. If the government regulated the mortgage industry toensure everybody had the correct incentives, then this would prevent the problem in the
future. There seems little doubt that the changes in the mortgage industry exacerbated thecrisis. However, their absence in many other similar crises over the years suggests that they
were not the primary cause.
We shall argue that the basic problem that caused the crisis was that there
was a bubble in real estate in the U.S. and also in a number of other countries
such as Spain and Ireland. What happened is that the bubble burst, and this caused
the huge problems in the securitized mortgage market and in the real economy.
The bubble was large and global in many ways. Figure 1 shows the Case-Shiller
10-city index since 1990. The figure illustrates the dramatic acceleration in house
price increases in the early 2000s and their fall since July 2006. Figure 2 shows6the year-on-year change in this index. It can be seen that the rise in house prices
started in the late 1990’s and then took off in 2003 and 2004.
What caused the bubble? We argue that there were two main causes. The mostimportant reason that the bubble was so big in the U.S. was the policies of the Federal
Reserve in 2003-2004. What they did to avoid a recession after the collapse of the tech
bubble in 2000 and the 9/11 terrorist attacks in 2001 was to cut interest rates to the very low
level of one percent. Taylor (2008) has argued that this was much lower than in previous
U.S. recessions relative to the economic indicators at the time captured by the “Taylor rule”.
During this period housing prices were already rising quite rapidly. For example, it can beseen from Figure 2 that the Case-Shiller 10-City composite index was growing at a rate
above 10 percent throughout this period.
The Federal Reserve created a significant incentive for people in many parts of the
U.S. to borrow at one percent and buy houses going up at a much higher rate. Unlike stock
prices, which follow random walks, Englund, Quigley and Redfearn (1998) have found thathouse prices are positively serially correlated. This means that if housing has been going up
recently then this may continue for some time to come. Lowering interest rates significantly
below the current rate of house price appreciation thus created a profitable opportunity tobuy property.
In addition there were various other public policies that made it advantageous to buy.
These included the tax advantages of being able to deduct interest on mortgages compared to
the non-deductibility of rent payments, plus a number of other policies to encourage poor
people to buy houses. All these factors created a large demand for houses that led to7

increases in house prices as shown in Figure 2. Even when the Federal Reserve eventually
started to raise interest rates in June of 2004, it was still worth borrowing because house
prices continued to rise at a rate above 10 percent until 2006 as shown in Figure 2. Thus theFederal Reserve’s low interest rate policy was the first factor that really caused property
prices to take off.
The U.S. was not the only country that experienced a bubble in property prices.
Spain and Ireland also had very large run ups in property prices. Taylor (2008) argues thatthese countries also had loose monetary policies relative to the Taylor rule. He points outthat Spain, which had the largest deviation from the rule, also had the biggest housing boom
as measured by the change in housing investment as a share of GDP. Other countries in theEurozone such as Germany did not have a housing boom because their inflation rates andother economic indicators were such that for them the European Central Bank’s interest rates
did not correspond to a loose monetary policy.
Loose monetary policy was not the only factor. As Allen and Gale (2000, 2007) haveargued, growth in credit is important for asset price bubbles. The second important elementin addition to low interest rates in the U.S., was global imbalances. These helped cause agrowth in lending in the countries with a loose monetary policy.
Why are there global imbalances? This is a complex issue. However, we will argue
that an important factor was the Asian Crisis of 1997. Many Asian economies, which haddone very well, like South Korea, Thailand, and Indonesia, fell into serious difficulties. In
the case of South Korea it was because its firms and banks had borrowed too much in foreign8

currency. The country turned to the International Monetary Fund (IMF) for help to see themthrough these difficult times.
In exchange for providing financial assistance, the IMF required South Korea to raiseinterest rates and to cut government spending. That is the exact opposite of what the U.S.
and Europe have done when faced with a very difficult crisis. One potential reason why thishappened is that the IMF is a European and U.S. dominated institution. The head of the IMF
up to now has always been a European while the head of the World Bank has always been an
American. Asian countries are not represented at the highest levels. That was part of thearrangements that were made when the Bretton Woods agreement was negotiated at the endof the Second World War, even though it is not explicitly stated anywhere in the treaty. The
Asian countries did not have much weight in the governance process and their quotas (i.e.
effectively their shareholdings) were small. All this implied that when the IMF imposed
harsh policies on the Asian countries at the end of the 1990s, there was no effective
mechanism for these countries to protest and argue that they had fundamentally soundeconomies.
The consequence was that many Asian countries such as South Korea realized they
had to become economically independent so that they would not need to go to the IMF to
obtain relief from a crisis in the future. To achieve this independence, these countries
accumulated trillions of dollars of assets. Figure 3 shows this accumulation of reserves by
Asian countries (here China, Hong Kong, Japan, Singapore, South Korea and Taiwan). In
contrast, Latin American and Central and Eastern European countries did not increase theirreserves during this period.

9The motivation for accumulating reserves of China, which is the largest holder, is
probably more complex than this. First, although they were not so directly affected by the
Asian crisis, similarly to other Asian countries China realized that it would be risky to seek
help from the IMF if they should need it in the future. Second, and perhaps more
importantly, it seems that China started accumulating reserves to avoid allowing its currency
to strengthen and damage its exports. Over time China’s reserves have continued toincrease. As of the end of the first quarter of 2010, they stood at the level of $2,447 billion.
One reason for the growth in reserves is the potential political influence this gives China,
particularly with the U.S. China has been increasing its military spending over the last few
years. Acquiring such large reserves gives them an alternative means of security.
How were the Asian countries to invest these reserves? One possibility could havebeen firms’ equity. However, it became difficult in particular for the Chinese to buy
companies. For example, when the Chinese state oil company CNOOC wanted to buy
Unocal in 2005 the transaction was blocked by the U.S. authorities on the grounds that
Unocal was a strategic firm. This happened on a number of other occasions. Thus, theChinese ended up having to invest mainly in debt instruments. They bought a large amountof Treasuries, Fannie and Freddie mortgage-backed securities, and many other debt
securities. Similarly, other countries acquiring reserves also invested large amounts in debt
securities. It can be argued that the large supply of debt helped to drive down lending
standards to ensure that there was enough demand for debt from house buyers and otherborrowers.

10

Loose monetary policies and the increase in debt instruments available because of
global imbalances were in our view two important factors responsible for the real estate
bubbles. However, various other factors also contributed to the bubble. One of these was theyen carry trade. This involved investors borrowing at zero interest rates in Japan andinvesting somewhere else such as in Australia and New Zealand at much higher rates. The
carry trade involved an exchange rate risk, but most of the time it was possible to earn asignificant return. There is not much information on how large the outflow of funds the yen
carry trade involved but it may well have helped contribute to the rise in property prices inAustralia, for example. Currently, there is the question as to how much the carry trade fromthe U.S. is contributing to property bubbles in China and other parts of Asia.
One important issue is the extent to which the problems in the real economy havebeen caused by the collapse of the bubble as opposed to spillovers to the real sector from the
problems in the financial sector. Spain provides an interesting example here. It had a verylarge property bubble. Its real economy has been very badly damaged with unemployment
doubling. However, its financial system is arguably the best regulated in the world. The
Bank of Spain implemented countercyclical loan loss ratios some time ago. As a result its
banks have come through the crisis much better than banks in other countries. For example,
Santander and BBVA were both able to expand their operations through mergers. While theother banks did not do as well, they still did not require the large bailouts observed in manyother countries. The savings banks or Cajas had more problems but again these have been
relatively limited. Thus Spain provides an example where it seems that the bursting of the
bubble has caused the most important damage to the economy. Figures 4 and 5 illustrate11this. Figure 4 shows the changes in GDP quarter by quarter. It can be seen that Japan andGermany had much larger GDP falls than the U.S., France and Spain. Figure 5 shows that
despite their large falls in GDP, Germany and Japan’s unemployment rates have not changed
very much since the start of the crisis. However, unemployment in the U.S. and Spain,
which had property bubbles, has approximately doubled. This observation emphasizes theimportant need to prevent bubbles.

3. Regulation and government intervention in the financial system
In order to design effective financial regulation it is necessary to have a clear idea ofthe market failures that make intervention necessary. The benefit of regulation is that it cancorrect market failures and potentially stop very damaging crises but the cost is that theregulation needed to prevent these crises may prevent the financial system from doing its
task of allocating resources. In turn that slows down growth, innovation and ultimately
damages efficiency. The task of good regulation is to reduce the frequency of crises without
impairing the operation of the financial system.
The main market failures in the financial system are panics, contagion, andmispricing due to limits to arbitrage. We next consider the various types of regulation thathave been used to correct these failures.

Designing capital regulation
Capital regulations have been the main tool for regulating banks in recent years.
These have been coordinated internationally through the Basel agreements. They are the12main tool for ensuring stability in the international financial system. The traditional
justification in the academic literature for capital regulation has been that it is needed tooffset moral hazard from deposit insurance (for an exception, see Hellman, Murdock andStiglitz (2000)). Because banks have access to low cost funds guaranteed by thegovernment, they have an incentive to take significant risks. If the risks pay off they receive
the upside, while if they do not the losses are borne by the government. The argument is that
capital regulation that ensures shareholders will lose significantly if losses are incurred isneeded to offset this incentive for banks to take risks.
This rationale raises the issue of why there is deposit insurance. The usual answer isthat this is needed to prevent bank runs that result from panics. If people know that the
government will cover any losses, it becomes rational for everybody to leave their money inthe banking system thus eliminating panics. However, in practice deposit insurance is only
for small deposits, it does not cover large deposits or wholesale funding. As a result it does
not solve the problem of panics. One possibility would be to guarantee all forms of shortterm debt. In this case there would again be a moral hazard problem. A better solution toprevent risk taking may be to remove deposit insurance and deal with the problem of runs
through lender of last resort policies. If depositors know that the central bank will provide
the needed liquidity if they attempt to withdraw early, they won’t withdraw and there won’t
be a run. Another view is provided by Skeie (2008). He argues that in modern economies
bank runs involve transfers of funds to other banks rather than withdrawals from the banking
system. As a result, the funds transferred out can be borrowed back through the interbank
markets. Skeie is able to show that for this reason there are no panics.

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Prevention of contagion is another rationale for capital regulation (see, e.g., Allen,
Babus, and Carletti (2009) for a survey of the literature on contagion). Contagion is themarket failure that central banks often use to justify intervention, as, for example, in the caseof the arranged takeover of Bear Stearns in March 2008. As Chairman Bernanke stressed in
his speech at Jackson Hole in August 2008 (Bernanke (2008)), Bear Stearns would havedefaulted if the Federal Reserve had not saved it. That would have led to a whole chain
reaction where many other financial institutions would have gone bankrupt. There might
have been a complete collapse of the financial system.
New theories of capital regulation based on preventing contagion are necessary. We
need to understand the determinants of the optimal capital levels to prevent contagion. At
the moment the literature on contagion is growing rapidly. However, as yet there are few
theories of capital regulation to prevent it.

What is the cost of equity capital?
One of the major problems in designing capital regulation is in modeling the costs ofequity finance for financial institutions. It is usually simply assumed in the literature that
equity is more costly than other forms of finance (see, for example, Gorton and Winton(2003)). However, it is not at all clear what this higher cost is due to. One simple answer isthat it is privately more costly because in many countries debt interest is tax deductible at thecorporate level but dividends are not. If this is why there is a desire to use debt rather thanequity, then the simple solution is to remove debt interest deductibility. We do not know of
any good public policy rationale for having this deductibility. It seems to have arisen as an

14

historical accident. When the corporate income tax was introduced interest was regarded asa cost of doing business in the same way that paying wages to workers was a cost. However,from a modern corporate finance perspective, this is not the correct way to think about it.
Equity and debt are just alternative ways of financing the firm. If removing interest
deductibility means financial institutions are willing or can be induced through regulation atlittle social cost to use more equity, then financial stability would be considerably enhanced.
Other possible rationales for the high cost of equity are agency problems within thefirm. According to this rationale the cost of equity is that it does not provide the correct
incentives to shareholders or managers to provide the right monitoring. High leverage isneeded to ensure this. There is little empirical evidence that this is in fact a severe problem.
For example, leverage in private equity and venture capital firms where the agency problem
seems much greater is typically less than in banks. This lack of a convincing rationale forthe social cost of equity suggests regulation should ensure capital buffers are made large
since there is little social cost to doing this. For example, if required capital ratios were 20
percent, the financial system would considerable more stable than is currently the case andmany more large shocks could be withstood.

Contingent convertible debt (CoCos)
It has been widely suggested that convertible debt should be issued by banks that
could be converted into equity in the event of a crisis. In this case it would not be necessary
for banks to raise capital in difficult times as it would already be available. The issue of thiskind of security by Lloyds in the U.K. is an example. This certainly sounds attractive but the15securities suffer from a number of potential problems. First, there will be the issue of
whether moral hazard is increased by such instruments. Second, why not use equity from thestart instead? As we have argued above, there is no good evidence that equity is costly
except for the interest deductibility of interest for the corporate interest tax and this should be
removed.

Capital adequacy regulation using accounting and market capital
Another important issue concerning current capital regulation is that it is based on
accounting book values rather than market values. When Wachovia failed during the recent
crisis its accounting capital was well above regulatory limits even though the market was nolonger willing to provide funds. There is no existing theory that we are aware of thatsuggests why capital regulation should be based entirely on accounting book values and not
at all on market values. We clearly need to investigate the extent to which capital adequacy
regulation should be based on market capital rather than accounting capital.

“Too big to fail” is not “Too big to liquidate”
As long as a financial institution can maintain its required regulatory capital andfunding from the market, then it will survive. An important issue is what happens when it
cannot do so. Should it be allowed to fail or be bailed out? One of the most importantprinciples guiding policy during the recent crisis has been that large institutions are “Too big
to fail.” The notion is that if a large financial institution is allowed to fail, this is going tocause many other institutions to fail all through the financial system. This is the contagion

16

problem discussed earlier. The way that this policy has been implemented is thatgovernments have bought warrants, preferred shares and common stock in many institutions
that would otherwise have failed. They have made it clear that these institutions will be
provided with the capital that they need in order to survive. The effect of this type ofintervention has been to provide a guarantee to long term bondholders as well. There is very
little in the way of current theory to justify these policies.
It can be argued that current approaches are the wrong way to deal with the “Too big
to fail” problem. As Lehman Brothers’ bankruptcy in September 2008 illustrated, contagion
is a very real problem and large banks and non-bank financial institutions should not beallowed to simply go bankrupt. However, “Too big to fail” does not mean that these
institutions should be allowed to survive.
It is a very bad precedent to provide failing banks with the funds they need tosurvive. In the future, it is likely that banks and other financial institutions will grow andbecome large knowing that they will not be allowed to fail. These banks will be willing totake large risks since they receive the payoffs if the gambles are successful while thegovernment bears any losses.
“Too big to fail” does not mean “Too big to liquidate.” Financial institutions should
definitely be prevented from failing in a chaotic way. The government should step in, takethem over and guarantee their short term liabilities in order to prevent contagion. The top
executives should be removed and pensions cancelled just as though the institution had gonebankrupt. Rather than allowing them to continue, these institutions should be liquidated in
an orderly manner, even if this may take several years. That would allow the other17

institutions that did not fail and that were well-run to expand and take over the failed
institution’s market share. Propping up the weak ones that did badly is not a good idea in thelong term. It rewards risk taking and, perhaps more importantly, it prevents prudence frombeing rewarded. Well-run banks that took limited risks and survived should be allowed tobenefit.
An important aspect of the scheme needed for the government to prevent contagion
by temporarily taking over failing institutions before liquidating them is to have bankruptcy
rules for all financial institutions that allow the equivalent of prompt corrective action forbanks. With a bank, the government can step in before it goes bankrupt and take control.
There doesn’t have to be a vote of the shareholders. Such a mechanism is needed for all
financial institutions.

Resolution of large complex cross-border financial institutions
A major difficulty in designing a framework that allows financial institutions to beliquidated is how to deal with large complex cross-border institutions. In particular, there is
the problem of which countries should bear any losses from an international mismatch ofassets and liabilities. This has proved a thorny problem for the European Union in designinga cross border regime to support its desire for a single market in financial services. For
countries without the EU’s political ties, it is an even more difficult problem. Designing
such a system is one of the most urgent tasks facing governments.
One possible way to proceed would be to eliminate cross border branching. Then
any subsidiaries would be regulated by the host country. These regulators would be charged

18

with ensuring that they were comfortable with any imbalances between assets and liabilities
in their country. They could require collateral in the form of securities to be posted to coverany excess of liabilities over assets within the country. The regulators would be responsiblefor intervening should a foreign subsidiary or home institution come close to failing andwould be responsible for covering any shortfalls of cross border assets and liabilities that
failure would lead to.
If capital regulation is designed so that large capital buffers are required, theninstitutions can be resolved when they hit thresholds of equity value that are also high, say 5
or 10 percent. This should ensure that the short and long term debt liabilities are more thancovered by the assets. Any remaining funds can paid to shareholders. Using large
thresholds in this way will help to minimize the likelihood that the assets of foreignsubsidiaries, including any collateral, are unable to cover the liabilities within the country.
A significant advantage of this type of scheme is that there is no need forinternational agreement on it. Each country can unilaterally impose it. This is not true ofother types of scheme where any gaps between assets and liabilities must covered from othercountries. In this case there must be agreement not to “ring fence” assets.

Limited government debt guarantees for financial institutions
In the current crisis holders of long term bank debt have effectively had a government
guarantee. An important issue is whether this is desirable. Such a guarantee prevents
disorder in bond markets, but again the guarantee provides undesirable long term precedents.
Going forward holders of bank debt will know it is guaranteed and will not have any

19incentive to exert market discipline. If failing banks are taken over and liquidated in anorderly manner as discussed above, it should be possible to impose losses on long term
bondholders. This should provide incentives for market discipline by bondholders.

Limits on leverage of financial institutions
Many financial institutions started the crisis with very high levels of leverage. It has
been widely argued that the deleveraging of these institutions during the fist stages of thefinancial crisis considerably exacerbated the effects of the crisis (see, e.g., Adrian and Shin(2009) and Greenlaw et al. (2008)). We agree with this view. Some limitations on theleverage of financial institutions seem desirable. However, implementing such restrictions inpractice may be problematic. The issue will be exactly what should be included in debt andwhat should be included in equity. Financial innovation will undoubtedly be used to try andcircumvent any restrictions.

Implementation of competition policy in the financial services sector
There has long been a tension between competition policy and financial stability (seeCarletti and Vives (2009)). It is only in recent years that competition policies have been
implemented in many countries. Often for stability reasons, countries have avoided
implementing competition in the banking sector as rigorously as in other sectors.
An interesting question that has been raised during the crisis is why is it that innormal times financial services firms make such large profits. One possibility is that it isbecause competition policy is not enforced properly. Although on the face of it financial

20

markets are very competitive, the nature of deviations from perfect competition is rather
different than in markets for goods. One illustration is “front running”. This is based on
knowledge of order flow by brokers and other participants in the market, which is extremely
valuable. For example, if a large buy order is executed then this will typically drive up
prices because market participants will deduce that the buyer has good information. If theprocessor of the order can trade before the large buy order is executed then it is possible to
make money. Aggregated over time this front running can be extremely profitable. In theequity markets in the U.S. this is illegal. There are very careful records kept of when orders
are received and brokers can’t trade on their own account before they execute customers’
orders. However, front running is not illegal in the U.S. bond markets.2 The large
investment banks have set up trading platforms for bonds that give them an advantage interms of knowledge of order flow. This has the potential to allow large profits from front
running.
It is important that deviations from perfect competition such as front running be
carefully investigated and regulated. Front running in the bond markets should be madeillegal just as it is in the equity markets. However, this is just one example where deviations
from perfect competition are different in financial services. There are many others that need
to be understood and prevented.
Restrictions on the size of financial institutions and their activities (the so-called“Volcker Rule”) have the potential to increase competition. Such limitations would havedone little to prevent the recent crisis but may nevertheless be desirable.
2

We are grateful to Krishna Ramaswamy for pointing this out to us.

21Macroprudential measures
As argued in Section 2, the basic cause of the recent crisis and many other crises is abubble in real estate prices. Perhaps the best way to prevent such bubbles is to avoid havingvery low interest rates at a time when property prices are surging. Once they have started,
the question is whether interest rates should be raised to prick them. It may be possible anddesirable to do this in economies with a high degree of homogeneity. However, doing thismay be difficult for political reasons. At least initially when such policies are first
introduced, it will be difficult to explain why it is worth causing a recession to burst a
property bubble. In heterogeneous economies like the U.S. and Eurozone, where there may
be a large amount of divergence in the rate of property price increases, using interest rates toprick bubbles will not be so desirable because of the areas that do not have bubbles. In thiscase it may be better to use other forms of macroprudential regulation to prevent bubbles.
One example would be limits on loan-to-value ratios that would be lowered as property
prices increase at a faster pace. This can be effective for residential property but may bedifficult to enforce for commercial property. The reason is that firms may be able to use
pyramids of companies that effectively increase leverage. Another measure is to haveproperty transfer taxes that are greater the higher is the rate of property price increases.

Mark-to-market or historic cost accounting?
Financial institutions have traditionally used historic cost accounting for many of
their assets. This is problematic if assets fall in value as they may able to hide this fact for22

significant periods of time. A good example is the S&L crisis in the U.S. in the 1980’s. Thiskind of episode encouraged a move to mark-to-market accounting in by the IASB and U.S.
FASB (see, e.g., Allen and Carletti (2008a) and Plantin, Sapra, and Shin (2008)). During therecent crisis it was not at all clear that market prices reflect fundamental values. It has been
widely suggested that limits to arbitrage allowed many asset prices, particularly those of
securitized products, to break free from fundamentals. As a result, mark-to-market
accounting came under severe criticism by financial institutions and was relaxed by the
FASB under political pressure from Congress.
How should the advantages and disadvantages of mark-to-market accounting bebalanced? As long as markets are efficient, mark-to-market accounting dominates.
However, if as during times of crisis they cease to be efficient, market prices do not provide
a good guide for regulators and investors. The key issue then becomes how to identify
whether financial markets are working properly or not. Allen and Carletti (2008b) suggestthat when market prices and model based prices diverge significantly (more than 2% say),financial institutions should publish both. If regulators and investors see many financial
institutions independently publishing different valuations they can deduce that financial
markets may no longer be efficient and can act accordingly.

A role for public sector banks in a mixed system
Some countries such as Chile with its Banco Estado have a publicly owned
commercial bank that competes with private sector banks. In times of crisis, such a bank can
expand and help stabilize the market as all market participants know that it is backed by the23

state and will not fail. That's what many central banks have effectively been doing bybuying large quantities of commercial paper. These central banks have become like largecommercial banks. But the officials in charge of central banks do not usually have much
expertise in running a commercial bank or know much about credit risk. It would be betterto have expertise in the public sector which allows the state to perform commercial banking
functions during times of crisis. These state institutions would also act as firebreaks andlimit the damage that can be done by contagion.

Reform of market structures
A number of commentators have argued that the over-the-counter markets for many
derivative contracts such as credit default swaps are opaque so that it is difficult to assesscounterparty risk. The suggestion is that these markets should be moved onto exchanges sothat the counterparty risk can be more systematically dealt with and eliminated. Thesesuggestions have a lot of merit. The problem is whether socially valuable niche markets forderivatives that do not have sufficient volumes to trade on exchanges will be eliminated as aresult of such measures. Reforms of over-the-counter markets should be carefully
considered.

Other measures
In the U.S. much has been made of the issue of consumer protection. While there
does seem evidence that consumers are taken advantage of by financial institutions, there is
not much evidence this was a major cause of the crisis. Much of the regulation that was put

24

in place in the 1930s and 1940s with the SEC Acts was similarly meant to protect
consumers. Strengthening this protection seems desirable. In other countries such measureswould be even more desirable. In many European countries, for example, there seems to bevery little in the way of consumer protection.
We have argued above that the removal of tax deductibility of interest will allow
large equity buffers at small social cost. Such equity buffers would make it unnecessary tohave countercyclical loan reserves. With low equity buffers such countercyclical loan
reserves are desirable.

4. Checks and balances on central banks
Going forward, what else should governments do to minimize the risk of a futurefinancial crisis? What reforms in addition to changes in financial regulation and the othertypes of intervention discussed above should be undertaken? There has been a tremendous
focus on the private sector and what the private sector did wrong in terms of taking excessive
risk. However, if the basic cause of the crisis was the real estate bubble and central banks
played a role in creating this, it is really the public sector that took the main risks. If there
had not been a bubble in real estate prices there would not have been a problem with
subprime mortgages. If property prices had remained stable or continued to rise at a slower
rate the default rate would have been manageable. It is therefore important to try to prevent
central banks from creating a similar problem going forward. In particular, we need todevelop a system that provides a check on central banks to lessen the chance that they take25

risks in the way that the Federal Reserve did when it set interest rates so low in 2003 and2004.
In a report on the Second Bank of the United States, John Quincy Adams wrote“Power for good, is power for evil, even in the hands of Omnipotence.”3 This statement
reflected the considerable distrust of the concentration of power that central banks
represented. The controversy over whether a central bank was desirable came to a head in
the debate on the re-chartering of the Second Bank in 1832. Although the bill was passed by
Congress it was vetoed by President Jackson and the veto was not overturned. There was nocentral bank in the U.S. from 1836 until 1914.
There were many serious financial crises during the period the U.S. had no central
bank. The severity of the recession following the 1907 banking panic led to a debate onwhether or not a central bank should be established in the U.S. The National Monetary
Commission investigated this issue and finally in 1914 the Federal Reserve System wasestablished. The initial organization of the Federal Reserve System differed from that of a
traditional central bank like the Bank of England. It had a regional structure and decision
making power was decentralized. This meant it was ineffective at managing crises. In 1933
there was another major banking panic which led to the closing of banks for an extended
period just after President Roosevelt took office. As a result of this, the Federal Reserve wasreformed in the Banking Act of 1935, which centralized power in the Board of Governors.
During the recent episode the Federal Reserve System managed the crisis well.
However, they did not do a good job in terms of preventing the crisis. In fact, as argued
3

Timberlake (1978, p. 39).

26

above, the case can be made that they were to a large extent to blame for the bubble thatcaused the crisis by setting interest rates so low at a time of rapidly rising real estate prices.
The centralization of power particularly in the Board of Governors and the Chairman meansthat there are very few constraints on what they can do.
After the inflationary experiences of the 1970s, many countries made their central
banks independent. The rationale was that if they are independent, they will not succumb topolitical pressure to cut interest rates and cause an inflationary boom every time there is anelection. This independence has worked very well for preventing inflation. However, thiscrisis has demonstrated that central bank independence may not be good for financial
stability. There are a few people making decisions that are very important and there is very
little in the way of checks and balances. For example, it seems that one person, Alan
Greenspan, played a large role in the decision to cut interest rates to one percent in 2003 andto maintain them there until 2004 so as to minimize the effects of the recession. According toreports at the time there was not much dissension within the Board of Governors in terms ofvotes against the position he took. The low interest rate policy worked in the short run, but atthe cost of a financial crisis and an enormous recession several years later. There should atleast have been more public debate about the wisdom of the low interest rate policy at thetime.
It is important to stress that we are not advocating a return to political control ofcentral banks. There are other alternatives to provide checks on the system. One possible
reform is to impose a mandate of financial stability on the Federal Reserve. This might help
to ensure the risks involved for financial stability in undertaking various policies would be27

more thoroughly discussed and assessed. Ensuring that there is a staff that focuses on
financial stability issues may help to achieve this.
Another possibility is to create a Financial Stability Board with its own staff andresources separate from the Federal Reserve that would not be dependent in any way on
them. Representatives from this Board could participate in Federal Open Market Committee
meetings and could be given several votes. Since their focus would be on financial stability
issues they would necessarily focus on the risk created by the public sector. The Federal
Reserve and monetary policy would be independent from politicians but there would bechecks and balances. We believe some kind of reform along these lines would be helpful
going forward.

5. Reforming the international financial architecture
As mentioned above, the IMF arguably exacerbated the problem of global imbalances
through the harsh policies that a number of countries were forced to undertake in the 1997
Asian Crisis. There was no reliable mechanism to stop this because the Asians areunderrepresented in the IMF governance process. In the last decade the Asian countries haveproduced a large proportion of global GDP. They are the ones with very large reserves
amounting to several trillion dollars. These are the countries with the economic power andarguably this should be reflected in the governance process of the important internationalorganizations. In the recent crisis Asian countries such as South Korea have done muchbetter than they did in 1997. Rather than raising interest rates and cutting government
expenditure as the IMF forced them to do then, South Korea cut interest rates and allowed a28

large fall in the value of their currency. In contrast to the 1997 crisis when unemployment
rose to more than 9 percent, it has only changed slightly in the current crisis. The reason thatthey were able to pursue these policies is that their large reserves meant they could maketheir own decisions and did not have to approach the IMF. They ran their reserves down but
they always maintained a large balance of reserves.
While it is individually advantageous for countries to self-insure by accumulating
reserves, this is an inefficient mechanism from a global perspective. One method ofaccumulating foreign exchange reserves is for a country to lower the consumption of its
people so that it can run a surplus. In this case there must be other countries that run deficits
to offset these surpluses. In practice the U.S. was the main country that did this. Anotherway for a country to accumulate foreign exchange reserves is to borrow funds using longterm debt and invest them in short term debt. The buildup of reserves and short term debt
through both mechanisms and their role in triggering the crisis meant that this was very
undesirable. This raises the question of what are the alternatives to self-insurance throughthe accumulation of reserves.
The IMF can perform an important role by providing funds to countries that are hit
by shocks. If countries could always rely on being treated fairly and equitably and not being
forced to implement harsh measures, there would not be a need to accumulate large levels ofreserves. In order for this to happen the IMF needs to reform its governance structure so that
Asian countries play a much larger role. This should be accompanied by an increase in
Asian staff at all levels. Unfortunately, current proposals do not go far enough in this regard

29and it seems unlikely that the IMF will be sufficiently reformed to make large reserves in
Asia unnecessary in the short to medium run.
A number of Chinese officials have made proposals for a global currency to replace
the dollar. This kind of approach has the great long run advantage that reserves can becreated initially without large transfers of resources and the attendant risk of a crisis. All
countries could be allocated enough reserves in the event of a crisis so that they could
survive shocks. The problem with this proposal is that there would be a need for an
institution to implement the currency. It would need to be like the IMF. There would again
be the issue of whether Asian countries would be properly represented in the governanceprocess.
A more likely medium term scenario is that the Chinese Rmb becomes fully
convertible and joins the U.S. dollar and the euro as the third major reserve currency. With
three reserve currencies there would be more scope for diversification of risks and China
itself would have very little need of reserves in just the same way that the U.S. and Eurozone
countries do not need significant reserves. In our view this is one of the most practicalsolutions to the global imbalances problem. China should start moving in the direction of
making the Rmb fully convertible as soon as possible.
One of the innovations that occurred during the crisis was the introduction of bilateralswap agreements between central banks for foreign exchange. This had the great advantage
of allowing many countries to obtain U.S. dollars, in particular. However, these were oneoff agreements. What many countries have argued is that these swap facilities need to bemade automatic so that they can rely on accessing them in times of crisis. Since these30

countries could then rely on this foreign exchange safety net, they would no longer need tohold such large reserves. There would of who would bear the credit risk in such agreements.
One possibility is for both sides to be required to post collateral. This foreign exchange
safety net would appear to be another important way to change the international financial
architecture to reduce the need for countries to hold foreign exchange reserves. Moreover,this scheme has the great advantage that it can be implemented in the short run.

6. Concluding remarks
We have suggested three important reforms. The first is that financial regulation andgovernment intervention should be based on a coherent intellectual framework of correcting
market failures and balancing its costs and benefits. The second is that central banks need tobe subject to more checks and balances than is currently the case. The third is that theinternational financial architecture needs to be reformed so that Asian countries can rely on
having access to foreign exchange in times of crisis.
Many reforms in a wide range of areas are needed to prevent another crisis fromoccurring. Unfortunately, there is very little consensus on what was the cause of the crisis
and what needs to be done to prevent another one occurring. In this paper we have outlined
the view that the crisis was caused by loose monetary policy and global imbalances and havesuggested a number of reforms. Much work remains to be done in detailing these policies.

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Figure 1
The Case-Shiller 10 Cities Composite Index

Source: S&P

35

Figure 2
Changes in the Case-Shiller 10-City Composite Index Year-onYear36

Figure 3
A Comparison of Foreign Exchange Reserves in Different Regions

Source: IMF website.
Asia is the six East Asian countries China, Hong Kong, Japan, Singapore, South Korea, Taiwan– province of China.

37

Figure 4
Percentage change in quarterly GDP

2

%

0

Q12007

Q22007

Q3- Q42007 2007

Q12008Q2- Q32008 2008

Q42008Q1- Q22009 2009

Q32009Q42009

-2
-4
US

Japan

France38

Germany

Spain

0

US
Japan
France39

Germany
Spain

Jan-2010

Nov-2009

Sep-2009

Jul-2009

May-2009

Mar-2009

Jan-2009

Nov-2008

Sep-2008

Jul-2008

May-2008

Mar-2008

Jan-2008

Nov-2007

Sep-2007

Jul-2007

May-2007

Mar-2007

Jan-2007%

Figure 5

Unemployment

20

15

10

5