Panel on Financial Regulation

Nov. 6, 2010


Three scholars who have extensively studied market crashes and crises shared their views on the future of financial regulation on Saturday, Nov. 6. The event was organized by undergraduate economics clubs Oeconomica and The Chicago Society. Guest panelists were:

Holmstrom opened the discussion by cautioning the student audience that it was difficult to offer complete answers about regulation because the causes of the crisis are not fully understood yet. “I think we agree that it had something to do with global imbalances of money. Money was sloshing around the world and ended up on the shores of the United States because this was the best, safest place," he said.

“Importantly, that had to do with the shadow banking system. We had financial innovations in that system, and we had a government that wanted to push money into households. Somewhere in that combination were the seeds of the problem.”

Diamond explained the crisis by paraphrasing Milton Friedman's famed dictum on inflation: “Financial crises are always and everywhere about short-term debt. If a lot of large institutions want to lend money for short term because it’s safe, the problem is that many assets are neither short-term nor safe. If there is any good way to do regulation, it’s to figure out what the right level of short-term debt is.”

Moderator Will Burgo asked panelist to address the lack of international cooperation when dealing with cross-border issues in financial crises. Allen said he felt the Dodd-Frank Act had not provided an adequate framework to deal bankruptcies of companies like Citibank and Bank of America that are operating in many countries. 

“What I think we need to do is to have a regulation whereby we get rid of cross border branching and only have subsidiaries that are regulated by the host country. They have to make sure the assets and liabilities match in some sense,” Allen said. “If they don’t match, they (companies)  need to post collateral, so if there is a problem we don’t have this issue of which country pays.”

Responding to an audience question, Holstrom and Diamond said that they felt the government response to the crisis was effective. “Given the massive amount of information to deal with and the speed at which this played out, I think they did fairly well,” Diamond said. “It looks like we are not going to lose so much money on the AIG bailout. Without something like the Troubled Asset Relief Program, we would have had a much worse crisis, with more failures and bank runs. The fact that they had to make it up as they went along and do some bailouts before TARP was approved showed that there wasn't a regulatory response in place, and that wasn't good.”

To a related question about financial institutions that grow too big to fail, Allen offered a different view: “Citibank has gone bankrupt every 10 years for 30 years. Saving it was not best approach,” he said. “You can’t allow banks to fail because of the risks of contagion. However, too big to fail is not too big to liquidate.” Although liquidation is often a better approach, he noted that in recent cases it might have taken years, because assets should not be sold off until their prices recover.

Holmstrom commented, “What is the right size of a bank? I don’t know, but every time you have a crisis they get bigger and bigger. We don’t have any evidence that a system of smaller banks wouldn’t pose as much systemic risk as big banks. I'm less certain we know answers.”

Diamond recommended regulating structure, not size: “My view is not that we should prohibit large banks at all, but if we think about the risks banks have, I think we should go back to higher capital requirements.”

This event is supported in part with generous grant from the CME Group Foundation.


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