Is regulation, or the lack thereof, risking a second great financial crisis?

• Position: A SYMPOSIUM OF VIEWS

Is the lack of effective financial market regulation exposing the United States and the world to a second crisis? Are U.S. financial markets still something of a "financial casino" thanks to failure to implement fully the Dodd-Frank financial market legislation and the so-called Volcker Rule restricting bank proprietary trading?

Or is the opposite true? Does the threat of the Volcker Rule and the overall uncertainty of U.S. financial market regulation have the potential to dramatically reduce market liquidity?

To what extent is financial market regulation, or the lack thereof, risking a second global financial meltdown?

ALLAN H. MELTZER

Allan H. Meltzer Professor of Political Economy, Tepper School of Business, Carnegie Mellon University, and Visiting Scholar, American Enterprise Institute

Crises have reoccurred throughout modern history. Nothing that legislators and administrators have done in recent years will change that. Most of the new regulation and the many new programs to make regulators responsible for judging risk and avoiding crises is well-intended but mistaken.

Before the 2008 financial crisis, the Federal Reserve Banks had scores of bank examiners in each of the largest U.S. banks. One of the leading examiners told me that they did not object to a single transaction. The Board of Governors approved off-balance-sheet entities that held mortgages and mortgage-backed securities but little if any equity capital. The Securities and Exchange Commission greatly increased the leverage of investment banks. Regulation failed.

Dodd-Frank gives the Secretary of the Treasury authority to decide whether a bank is too big to fail. That does not change past practice. Can anyone believe that in the midst of a crisis, the Secretary will decide to let a large bank or financial institution fail? Everyone will remind the Secretary of Lehman Brothers.

I find no reason to believe that, with the passage of time, the regulators would not again be captured by the large banks and financial firms.

The right way to reduce risk is to make the risk-takers bear the risk. Instead of hundreds of regulations, I offer four principles to reform banking and financial markets. The principles shift responsibility back to the bankers. With increased equity capital, the principle stockholders will insist on prudent decisions.

First, we need a clearly stated rule, publicly announced, governing the lender of last resort. In one hundred years, the Federal Reserve has never announced any rule or principle governing lender-of-last-resort policy.

Second, we should return to protecting the payment system, not the banks or financial institutions.

Third, by implementing the first two rules, we will prevent problems from spreading to other institutions that hold collateral acceptable for discount under the lender role.

And last, we should require regulated very large banks to hold a minimum of 15 percent equity capital against all assets. This is the rule in the bipartisan Brown-Vitter bill.

E. GERALD CORRIGAN

Managing Director, Goldman Sachs Group, and former President, Federal Reserve Bank of New York

The aftermath of the financial crisis of 2007-08--in economic, financial, and human terms--has been a slow and frustrating process as we strive to restore more normal patterns of economic growth while at the same time putting in place the essential building blocks that will secure a more stable financial system.

Given the complexity of the causes and contributing factors to the crisis, it should not surprise us that the post-crisis legislative and regulatory reform agenda is equally, if not more, complex. For that reason, some time ago I concluded as a matter of priority that the most pressing building blocks for enhanced financial stability were four in number as follows:

* First, the Basel standards for capital and liquidity, which should be viewed as complementary disciplines by individual institutions and their supervisors.

* Second, the development of a workable framework of recovery plans (often called living wills) on the part of troubled institutions and their supervisors to stabilize such institutions and promote their recovery short of bankruptcy or failure.

* Third, the development of a comprehensive framework of enhanced resolution authority that would permit the orderly wind-down of seriously damaged systemically important financial institutions without reliance on taxpayer money.

* Fourth, the achievement of a high degree of cross-border consistency in emerging regulations, laws, and standards that comprise the core elements of the post-crisis reform agenda.

Progress is being made in all of these areas, especially the Basel capital and liquidity standards. However, considerable further time and effort will be needed to round out the design and ultimate execution of these priority building blocks with particular focus on the challenges associated with enhanced resolution authority as it applies to systemically important financial institutions having an international footprint. Indeed, the design and execution of enhanced resolution authority is, by far, the most demanding and complex of the priority building blocks.

Having said that, I must acknowledge that the progress made over the past two years in this area has exceeded my expectations. Of particular note in this regard has been the cooperative efforts in the United States and the United Kingdom between the Federal Deposit Insurance Corporation, the Federal Reserve, and the Bank of England in a setting in which regulators and practitioners are learning from each other as to how best cope with the dozens of highly complex issues associated with the execution of enhanced resolution authority.

The four priority building blocks cited above are necessary--but by no means sufficient--conditions for enhanced financial stability. Several obstacles stand in the way of crossing the bridge from necessity to sufficiency. For example, final standards regarding the Volcker Rule and Single Counterparty Credit Limits among systemically important financial institutions have yet to be adopted. Beyond that, it remains very difficult (to put it mildly) for policymakers and practitioners to fully grasp the cumulative impact of the many interconnected elements of the reform agenda, including their potential implications for market liquidity.

All of this begs a much larger, and much more important, question, namely: Is today's system of financial intermediation safer and sounder than it was in the years leading to the crisis? My answer to that question is "yes." Having said that, it would be premature to declare victory, especially since the economic recovery remains fragile amid continuing uncertainties as to how fiscal and monetary policies in the United States will play out over the next several years. Nevertheless, I am confident that we can further ratchet up the standard of financial stability, thereby further reducing the probabilities of major financial shocks and the damage caused by such events.

DEAN BAKER

Co-Director, Center for Economic and Policy Research

Most of the discussion of the risk of a new financial crisis overlooks the most basic point about the last crisis: it was the result of an asset bubble. The crisis was not merely the result of irresponsible mortgage issuance and highly leveraged financial institutions, it also depended on the value of the underlying asset--housing--becoming sharply out of line with the fundamentals of the market.

This point is essential, because the last financial crisis was not only the result of failed regulatory policy, but also the failure of the Federal Reserve Board to take note of an unprecedented run-up in house prices. If the Fed had taken steps to counter the run-up in house prices, then the failed regulatory policy could not have led to a financial crisis.

The financial reforms in Dodd-Frank provide little basis for believing the regulatory structure has been sufficiently strengthened to prevent...