Principles for future financial regulation (updated)

This post by Stephany Griffith-Jones states: “There are two broad principles on which future financial regulation needs to be built.” I agreed with this statement and read with curiosity her principles. I don't think her first basic principle is sufficient. (Her second is pretty similar to my second principle below.) She proposes countercyclical capital requirements. Like the "liquidity charges" proposed here, I think these authors are over-optimistic about the capacity of regulators to make good decisions about things like the price of insurance and the correct dynamic level of capital.

The environment in which regulators operate needs to be remembered: the entities with the most time and energy to communicate with regulators are the regulated firms themselves. This creates an inherent tendency in regulators to under-regulate especially when the economy is stable over a long period of time. The fact that in a crisis the regulators will be blamed for capital requirements that are too low or for under pricing insurance works to absolve financial institutions for their own failures in a way that is totally inappropriate.

In short, the incentives in these schemes are all wrong. When crises occur and financial institutions fail, we need to have a regulatory structure that makes it clear that these failures are completely and entirely the fault of the financial institutions themselves -- for the simple reason that the ones with the greatest ability to prevent the crises are the financial institutions.

I would propose one meta-principle from which two subsequent principles follow:

I. Competition without bankruptcy and failure is not competition.

This principle implies:

(i) All financial institutions that carry government guarantees should be protected from so-called market competition. Banks with deposit insurance need to be considered public utilities: They can earn a rate of return deemed fair by regulators, but will be safe investments with a stable, but never remarkable return. If money market funds are to be brought permanently under the federal safety net, then they will be treated similarly. In this case, we need to recognize that the terms of the “competition” between money market funds and banks will be set by government policy, not by the market.

The logic behind this view is simple: there are certain core functions of the financial system that the government chooses to guarantee. One of these is bank deposits. As long as bank deposits constitute a core function guaranteed by the government, any close substitute for that core function will also end up (possibly ex post) with a guarantee. Example: money market funds.

Thus, it makes no sense for there to be competition in guaranteed core functions of the financial system. The financial sector may be permitted to develop such alternatives, but as soon as they are large enough to compete with the guaranteed core function, the playing field must be evened by charging them guarantee fees and bringing them into the protected financial sector.

(ii) Any financial institutions that are left open to competitive market forces must be allowed to fail on a regular basis. In order to make the commitment to failure credible, the government will probably have to regulate the size of these financial institutions individually, the extent of their liabilities to the protected financial sector, the extent of their (conditional) claims on the protected financial sector and the size of the markets they create in the aggregate. Markets that grow large will have to move to regulated exchanges, so they can be carefully monitored to ensure that they carry no risks for the protected financial sector.