Federal Reserve Research Paper

Wednesday, May 13, 2009

Any command-and-control regime of regulation creates incentives for getting around the rules, i.e., for regulatory arbitrage. Compared to the first Basel accord, Basel II attempts to be more sophisticated in terms of making capital requirements contingent on fine measures of risk; this is an attempt to cut down on such regulatory arbitrage. Nevertheless, as recent experience suggests, this is a difficult task, no matter how elaborate a risk-measurement system one builds into the regulatory structure.

One complicating factor is the viral nature of financial innovation. For example, one might argue that AAA-rated CDOs were a successful product precisely because they filled a demand on the part of institutions for assets that yielded unusually high returns given their low regulatory capital requirements. In other words, financial innovation created a set of securities that were highly effective at exploiting skewed incentives and regulatory loopholes. (See, e.g., Coval, Jurek and Stafford (2008a b), and Benmelech and Dlugosz (2008).)

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For example, there have been calls to impose new regulations on the rating agencies... This is the most fundamental message that emerges from taking a viral view of the process of financial innovation--the problem one is trying to fight is always mutating. Indeed, a somewhat more ominous implication of this view is that the seeds of the next crisis may be unwittingly planted by the regulatory responses to the current one: whatever new rules are written in the coming months will spawn a new set of mutations whose properties are hard to anticipate.

Rethinking Capital Regulation, Kashyap et al, August 2008, Prepared for the Federal Reserve Bank of Kansas City symposium on "Maintaining Stability in a Changing Financial System," Pages 20-22, http://www.kansascityfed.org/publicat/sympos/2008/KashyapRajanStein.08.08.08.pdf.

...using an analogy from Hoenig (2008), instead of attempting to write the most comprehensive fire code possible, we should give some thought to installing more sprinklers.

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I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.

Remarks by Governor Ben S. Bernanke, At the Conference to Honor Milton Friedman, University of Chicago, Chicago, Illinois, November 8, 2002, http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021108/default.htm.