How to Make U.S. Financial Regulation Work Again

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3. Restore transparency. Businesses acquired by private equity firms do not need to report in precisely the same way as publicly traded firms. But the compensation of fund managers and the source of their payments (retained earnings or additional capitalization) need to be clear to all investors. The role of market to model in assessing compensation must be clear—and possibly be restricted by regulation. The positions of nonbank financial institutions and their exposure in unregulated nontraditional financial instruments needs to be made more transparent as well.

4. Apply more complex capital adequacy requirements, especially to nontraditional financial institutions and shadow banks and nontraditional financial instruments. This is the most technical, most complex, and probably least controversial reform. It is essential in an era of increasing interconnectivity among financial firms broadly construed, when the largest nonbanking financial institutions can jeopardize the global economy's stability. Securities firms can determine capital adequacy on their net positions; a firm that is long $5 billion in U.S. Treasuries in one office and short $4 billion in another needs merely to provide capital for its net $1 billion exposure. It is not entirely clear what this form of netting means with interest rate swaps. A firm that holds several billion in debt that it is responsible for paying, as well as comparable billions in debt for which it is receiving payment, may look secure. But if anything jeopardizes its ability to make payments, even temporarily, the downstream repercussions for institutions, banks, and others may be catastrophic. Regulators have not yet figured out what this regulatory regime should be.

What should regulation not do?

There are several mistakes to avoid in our next round of financial regulation.

1. It should not interfere with the true function of finance, which is to provide funding for industry and to reward investment.

2. It should not interfere with financial innovation, which has been essential to the growth of industry and social wealth. Although much maligned today, securitization of mortgages and credit card debt has been essential to fostering increased competition in consumer lending and increased long term liquidity for real estate development. Even the despised swaps serve a valuable purpose in allowing institutions to tailor payment schedules to their needs.

3. It should not sow the seeds of the next financial disaster by driving derivatives and innovative instruments further out of the banking system—and out of the secondary shadow banking system—turning them into entirely unregulated and completely opaque instruments created and traded by unregulated financial entities.

4. It should not so restrict the earnings of officers of currently endangered banks that they are willing to let their institutions go under rather than accept the funds needed to save them.

What do we need to worry about?

We need to worry about the migration of trading to institutions with even less regulation. We need to worry about the migration of investors to even less regulated institutions—much as they did when Sarbanes-Oxley was introduced—in hopes of earning higher profits. We need to worry about well-intentioned but vengeful regulation that solves our current problems but creates conditions that inevitably contribute to the next crisis.

As we did in responding to the market crash of 1987, we need to coordinate regulatory response. When I worked with regulators in both Washington and London, we needed to make sure that regulatory change was first, sufficient to protect investors and to prevent abuse and second, not so strict as to drive institutions and investors to less-regulated markets. Sufficient regulation provides a competitive advantage. Too little regulation can destroy investor confidence, especially during our current meltdown, while too much regulation inspires competition in lax execution to lure institutions fleeing what they perceive to be regulatory excesses.

What do we not>/em> need to worry about?