Financial Regulation Going
ForwardFranklin Allen
University of Pennsylvania
Elena Carletti
European University InstituteBank of JapanMay 26-27, 2010

What caused the crisis?
• The conventional wisdom used to be that the basic
cause of the crisis was bad incentives in the mortgage
industry
But now we know much more was going on…
• The large global impact of the crisis suggests that theproblems with subprime mortgages were a symptom
rather than the cause• The main problem is that there was a bubble inproperty prices in the U.S., Spain, Ireland andelsewhere, and we are now suffering the fallout fromthe collapse of that2Current Crisis:
Case-Shiller 10 Cities Composite

Source=S&P

3

Percentage Change in
Case-Shiller 10 Cities Composite

Source=S&P

4

What caused the bubble?
• The monetary policies of central banks particularly
the U.S. Federal Reserve and ECB in some countries
were too loose – they focused too much on consumer
price inflation and ignored asset price inflation• Global imbalances – the Asian crisis of 1997 and thepolicies of the IMF led to a desire among Asian
governments to acquire reserves5Reserves: A Comparison

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To summarize:• The first aspect of the problem was the development
and bursting of the property bubble• The second aspect was that this problem wasconsiderably exacerbated by the poor functioning of
the financial system in the crisis• How much of the disruption to the real economy isdue to the bursting of the bubble and how much isdue to the financial crisis?
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Spain• One of the largest property bubbles occurred in Spain• The bursting of this bubble has devastated the real
economy – unemployment has doubled to a level ofalmost 20%• BUT the financial system, and in particular the banks
such as Santander and BBVA have come through thecrisis very well until the problems in Greece• This suggests that the bursting of the bubble cancause tremendous damage to the real economy even if
the financial system remains strong8

% in quarterly GDPquarter on quarter
20%

Q12007

Q22007

Q3- Q42007 2007

Q12008Q2- Q32008 2008

Q42008Q1- Q22009 2009

Q32009Q42009-2-4
USJapanFranceGermanySpain
90USJapan
FranceGermany

Jan-2010

Nov-2009

Sep-2009

Jul-2009

May-2009Mar-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%

Unemployment

20

15

10

5Spain10

Why has the financial system
performed so poorly?
• Why didn’t regulation help?
• Banking regulation is different from other kinds ofregulation in that there is no wide agreement on themarket failures it is designed to correct• It is backward looking in the sense that it was put inplace to prevent the recurrence of past types of crises
11Policy responses• Banking regulation needs to focus on correctingmarket failures rather than being imposed ad hoc as
has been done historically• Central banks and governments need to be much
more focused on preventing bubbles and global
imbalances than in the past – this is the real cause ofthe crisis• The international financial architecture needs to bereformed
12Regulation•

What are the benefits and costs of regulation?

•The Basel agreements illustrate the lack of a widelyagreed theoretical framework•

What exactly are important the market failures?
• Panics• Contagion• Mispricing due to limits to arbitrage
13Banking regulation• Capital regulation main tool for regulation in recentyears• What are the market failures this regulation issolving?
• Basel agreements are silent on this issue• Contagion is one of the most important market
failures capital regulation can help prevent
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Banking regulation (cont.)• What is the cost of capital buffers – i.e. why is equity
more costly than other forms of finance?
• Most plausible explanation of the high cost of equity
finance is that there is a tax subsidy to debt in theform of interest deductibility• If this is the case then the best policy is to remove theinterest deductibility of debt so that large capital
buffers are both privately and socially optimal – it isnot clear there is any good justification for the tax
deductibility of interest
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Systemically important financial
institutions• “Too big to fail” is not “Too big to liquidate”• The government needs to guarantee the short term
commitments of failing banks to prevent contagion• When a bank fails or is close to failure thegovernment should step in, take it over and resolve it– the top 5 executives should be removed immediately– all employee pension claims should be eliminated– over the next few years the bank should be liquidated• International issues
16Resolving large cross-border financial
institutions• Eliminate cross-border branches and require
subsidiaries• Regulators should monitor the degree of mismatch
between assets and liabilities within the country withsignificant mismatches leading to posting of collateral• Large equity buffers of 20 percent in terms ofaccounting and market capital• Banks resolved when equity falls below 5 percent
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Limits to arbitrage and the mispricingof assets• Many people believe that prices of securitized
products broke free from fundamentals and this is
why prices fell so low• TARP and many other plans were designed to restore
prices to their proper level – more effective policies
need to be developed to ensure asset prices reflectfundamentals• Mark-to-market versus historic cost accounting
18Competition in financial services• There is much discussion about bankers’ compensation
but the real issue is how banks are able to make somuch money that they can pay such high compensation• What is really needed is a full competition review that
establishes how they make so much money– Market structures that are anticompetitive?
– Front running in the bond market?
– Conflicts of interest – e.g. Goldman Sachs– Swapping privileged information about takeovers and soforth with other institutions to make high profits on theirproprietary trading?
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Reform of central banks• Central bank independence works well for combating
inflation but not for financial stability• The private sector is being criticized for taking somuch risk but it is really the Federal Reserve, ECB
and other central banks that took the risks, e.g. low
interest rates in 2003 and currently quantitative easing• There needs to be some check and balancemechanism such as a Financial Stability Board thathelps to control public sector risk taking• Macroprudential measures

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Global imbalances• Self-insurance by Asian countries through large
reserves is optimal for them, e.g. South Korea• However, it is a very inefficient mechanism from a
global perspective• Reform of the IMF? Global currency?
• Regional risk sharing• Bilateral swaps to give foreign exchange safety net• Rmb as a reserve currency
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Other measures• Reform of derivatives market structures• Size and activity caps
• Consumer protection• Limits on leverage• Public sector banks

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