Preventing another collapse

THE ECONOMIC crisis of the last two years has clearly revealed flaws in regulation. But there is less clarity on how radical reforms need to be. Is it enough to plug obvious gaps and then get back to business as before? Or is something more fundamental needed?

Better regulation is not the whole answer of course; some of the work will be done by the markets. Banks have had a terrible shock. They don't need telling that sub-prime mortgages can damage their health. They know only too well that their risk management systems prepared them only for showers not for hurricanes. They have learned lessons and, if they become forgetful, their investors will remind them.

Improving private sector risk controls only takes you so far. Firms need to maximize profits. For a bank the ideal risk management system is one that lets it take profits when they are available and to close out risks at the last minute, ahead of the competititon. The investment banks that did best in this crisis were not those that "sat out the dance" but those that reacted most quickly and cohesively when the music stopped.

However, in a competition someone always comes last, and the failure of the weak can start a chain reaction that threatens even the strongest institutions. More generally, the financial system is much more than the sum of its parts. It is not enough to ensure that each firm is sound. Behavior that may be safe and rational for one firm can be disastrous when replicated many times.

There are four key areas in which the change has to go beyond the incremental: discipline on the biggest firms, using capital requirements to dampen the economic cycle, international cooperation, and institutional change.

First, we need to reestablish market disciplines which have been weakened by the government guarantees of all retail deposits, all big institutions and much more besides. The markets already provide banks considered "too big to fail" with easier credit than others and thus enable them to take bigger risks. In the short term, that should help to shorten the recession, but it could make the next boom even worse.

We need insolvency regimes that could be used on more complex firms and we should require higher capital and liquidity buffers for the largest firms than for others (thus offsetting the market's discount for size). We need also to push more trading onto exchanges (improving transparency) and through central counterparties (reducing counterparty risk).

Second, we need to "protect the economy" against the financial system's swings from gloom to exuberance and back again. We should raise capital requirements as a percentage of assets in good times and reduce them in bad times. That will stabilize leverage and make the cycle less fierce.

Third, we need far closer international cooperation. Lehmans' closure would have been difficult in any circumstances. Working under different national regimes with no shared understanding of corporate structure or any transparency on their interlocking assets and liabilities made it a catastrophe. Stronger colleges of supervisors and agreed contingency plans for global firms are the first step; a single accounting regime and stronger controls against regulatory arbitrage should follow.

Finally, we need to restructure our institutions to make them better at identifying and reducing systemic risk. This crash has shown again how difficult it is for any regulator to challenge prevailing market opinion.

Some degree of regulatory capture and common thinking is almost inevitable when the regulator and firms are in constant negotiations over incremental changes in business strategies and structures. One protection against that is to give a powerful voice in setting regulatory requirements to a body which is not engaged in day to day supervision but has a responsibility to monitor the system as a whole. Where the Central Bank has limited direct supervisory responsibilities, as in the UK or the euro area, it is well placed to play that role. A key decision for the United States is whether to give this "system overseer" role to the Fed or whether to make it the supervisor of systemic institutions and find some other body to take the more detached "top down" view.