Paths Taken and Paths Forward Ivan J Kirov Fed Challenge Feb

Capital Savers Investment vehicles Financial Intermediation Banks Financial Markets Investment Firms Entrepreneurs  Financial Institutions  Solve informational asymmetry  Leverage economies of scale

 Bank “Self-Regulation” ◦ At sign of trouble:  Creditors pull out  Depositors withdraw  Difficult to raise money in capital markets  Hence capital kept on hand Discipline DepositorsCreditors Money Markets

 Finance is systemically important to the functioning of the economy Real Economy Transmission Banks Financial Distress - I - Y- ΔY Credit tightens Less Profitability and Growth

 Liquidity (Lender of last resort) ◦ Traditional purview of central banks  Deposit insurance ◦ In US, from Depression  Creditor guarantees ◦ Mostly from last crisis ◦ AIG ◦ Citi

 Guarantees reduce risk in holding bank debt  Moreover, they insulate creditors from loss ◦ Risk-taking proliferates  Financial institutions’ incentives become out of line with those of regulators Source: Economist Banks’ Equity as % of Assets

 To avoid moral hazard implicit in support, governments impose financial regulatory structures Capital Structural security Asset buffer Liquidity Rapid- response Psychological buffer Pay Align incentives “Micro” buffer Accounting Trans-border coordination Transparency

 Basel-2: Current main international regulatory framework  Financial institutions must keep on hand at least 4% of risk-weighted assets ◦ “On hand”: Tier-1 capital ◦ “Risk-weighted”: According to GAAP, but in practice a firm-specific definition  Problems ◦ Tier-1 capital includes debt-like instruments ◦ Low capital margin ◦ Limited regulation of leverage

 Tobin Tax  Britain’s Bonus Tax  Obama’s Bank Levy  The Volcker Rule  Basel-3

 Originated by James Tobin in 1973  FX transactions above “optimal level” – tax to bring them in line with public optimum.  Financial Tobin Tax is not strictly a form of regulation; more like enforced downsizing.  Problems: ◦ How do governments know finance’s “optimal size”?

 Dec. 10, 2009: UK gov’t imposes 50% tax rate on bank bonuses exceeding £25,000  Largely politically motivated

 Tax on financial firms with >$50 billion in assets  Would raise $90bn over 10 years  To cover TARP fund  Applies mostly to risky activities ◦ Proprietary trading desks  In practice: small, symbolic  Principle? Source: New York Times

 Semi-reinstatement of Glass-Steagall  Banks (or just deposit-taking institutions?) cannot engage in proprietary trading or invest in hedge funds or PE funds  Details still pending Congressional crucible InstitutionEstimated Revenue Loss Goldman Sachs$4.5 bn JPMorgan$2 bn Citigroup~ $500 mil Source: New York Times

 Work-in-progress: refinement of Basel-2 rules  General thrust ◦ Safe “Tier 1” capital more narrowly defined (mostly only equity) ◦ Financial institutions cannot use proprietary risk models ◦ Liquidity: banks must withstand 30-day credit freeze ◦ Capital requirements increased to 6-8% of risk- adjusted assets

 Liquidity regulation  Institutions pay for not-so-implicit guarantees  “Convertible capital”  Balance between institution-specific and system-wide regulation

 Julian Simon: The Dismal Science?  “One can hardly imagine, I think, how poor we would be today were it not for the rapid population growth of the past to which we owe the enormous number of technological advances enjoyed today.... If I could re-do the history of the world, halving population size each year from the beginning of time on some random basis, I would not do it for fear of losing Mozart in the process.” -Edmund S. Phelps