Financial Regulation: A Little Common Sense, Please

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The economy and taxpayers are at risk to many kinds of leveraged firms whether it's called an investment bank, insurance company, commercial bank, or hedge fund. The key is to end up with a modernized, streamlined regulatory structure that reflects the reality of competition and overlap among financial-services companies.

Rules for Leveraged Firms

A regulatory regime that essentially treats leveraged financial services the same is based on the insight that the forces that brought us to this sorry state of affairs are powerful. That point was brought home in rereading a remarkable speech given in 1985 by Albert M. Wojnilower, then the well-known chief economist at First Boston. In Financial Change in the United States, Wojnilower reviewed the dramatic transformation of the U.S. financial system over the previous two decades. He clearly saw how competition was destroying compartments, propelled in large part by zeal among financiers to evade regulations, the march of information and communications technologies, the erosion of national and international barriers, and the dependence of the financial system on government bailouts. He didn't like it. The trend worried him. Yet the elements he identified strengthened over the subsequent two decades, giving free rein to "the ingrained human propensities to borrow, lend, speculate, and gamble."

Leveraged financial firms should be required to carry higher capital ratios. The requirements surrounding greater transparency are good, too. But there are a number of intriguing ideas that essentially rely on creating automatic market-based mechanisms that reinforce regulatory discipline, punish wrongdoers, and limit the odds of a government handout. For instance, Rajan proposes that highly leveraged financial firms be required to issue debt with covenants that automatically convert the bondholders into equity owners in times of trouble. The trigger for the ownership swap could be regulators saying the system is in crisis or the firm's finances breach certain safe ratios of capital and assets. The requirement would include everyone from Goldman Sachs (GS) to Citigroup (C) to John Hancock. The covenant could certainly make existing owners wary of making too-risky bets. It certainly would help keep losses painfully private.

That market-based system could be strengthened by additional measures. For example, highly geared financial institutions also could be required to sell capital insurance bonds to sovereign wealth funds, private equity firms, and other deep-pocket investors. The proceeds would be invested in default-free Treasury bonds and placed in a custodial account, say, at State Street Bank (STT). The risky firms in question would pay the bond buyer an insurance premium and the buyer would pocket the interest payments on the Treasury securities. Yet under certain dire circumstances the money in the fund would be released to shore up the finances of the troubled firm.

A combination of uniform government regulation reinforced by market mechanisms could bring moderation to all things in finance. After all, no one wants to eliminate booms. "In any case, the animal spirits of enterprise, risk-taking, and innovation will always breed booms rather than sleepy and stable environments," wrote the late Peter Bernstein, the dean of finance economists.

But booms mean there will be busts. A lighter but more standardized regulatory system that allows financiers to take moderate risks, no matter what their business, but quickly and automatically punishes excessive gambling could be the way to go.

Farrell is contributing economics editor for BusinessWeek. You can also hear him on American Public Media's nationally syndicated finance program, Marketplace Money, as well as on public radio's business program Marketplace. His Sound Money column appears on BusinessWeek.com.

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