Given the ongoing debate about "too big to fail" and whether we should head back to the days of the
Glass-Steagal Act, then here is a slightly different slant on the problem of systematic risk put forward in an
article by Avinash D. Persaud.
In the article, Avinash makes the very good point that increasing capital requirements across the board is not the only response that regulators should consider, and that the risk of a financial product cannot be determined in isolation of who is holding
"At the heart of modern regulation is the erroneous view that risk is a quantifiable property of an asset. But risk isn't singular. There are credit, liquidity, and market risks, for instance—and different parts of the financial system have different
capacities to hedge each. Thus, risk has as much to do with who is holding an asset as with what that asset is. The notion—popular in the U.S. Congress—that there are "safe" instruments to be promoted and "risky" ones to be banned is deceptive."
Obviously the last point is very relevant to the OTC markets at the moment. Avinash suggests that capital requirements should be tailored to what type of organisation is holding a risk and that organisations ability to hedge it, and outlines past mistakes
made by regulators:
"By requiring banks to set aside more capital for credit risks than nonbanks must, regulators unintentionally encouraged banks to shift their credit risks to those who wanted the extra yield but had limited ability to hedge this type of risk. By not requiring
banks to put aside capital for maturity mismatches, they encouraged banks to take on liquidity risks they couldn't offset. Moreover, by supporting mark-to-market asset valuations (which make institutions value holdings at their current price) and short-term
solvency requirements, regulators discouraged insurers and pension funds from taking the very liquidity risks they are best suited for."
On banks and credit risk, then for those interested there is a good regulatory arbitrage example for credit risk described in the following
article. Fundamentally I think the paragraph above illustrates some of the reasons why it is right to worry about rushing in new regulation too quickly - certainly things need to change but when dealing with large and complex systems (i.e. in this case
Financial Markets) changes should be introduced incrementally in order to understand how the system responds.
Given the political imperative to "do something" then regulators find it all too tempting to stick their noses in everywhere, even in areas that did not lead us to the current crisis - take for instance the regulatory initiatives over the past year in
hedge fund regulation and more recently the dangers of "dark pools" (at
least dark pools sound scary I guess?). Where will the next "bogey man" appear on the regulator's radar and what will be the unintended consequences of government pressure on regulators to keep us all "safe"?