(updated October 2003), www.worldbook.org/finance/html/database_sfd.html.
248
PA R T I I I
Financial Institutions
W H I T H E R F I N A N C I A L R E G U L AT I O N A F T E R T H E S U B P R I M E
F I N A N C I A L C R I S I S ?
The recent subprime financial crisis has led to banking crises throughout the world,
and it is too soon to tell how large the costs of rescuing the banks will be as a result
of this episode (which is why they are not listed in Table 10-3). Given the size of
the bailouts and the nationalization of so many financial institutions, the system of
financial regulation will surely never be the same. Here we can speculate on
where financial regulation might be heading as a result of this crisis.
The financial innovations of subprime and Alt-A mortgages and structured
credit products like collateralized debt obligations helped trigger the crisis.
Although these innovations have the positive potential for promoting the democ-
ratization of credit, that is, increasing the access of poorer members of society to
credit, they went horribly wrong because of the agency problems of the originate-
to-distribute business model. Future regulation will surely focus on limiting these
agency problems to make the originate-to-distribute model and the financial sys-
tem overall work better. Eight types of regulation likely to be seen in the future
are described below.
Systemic
banking crises
Episodes of
nonsystemic
banking crises
No crises
Insufficient
information
F I G U R E 10 - 1
Banking Crises Throughout the World Since 1970
Source:
Gerard Caprio and Daniela Klingebiel, Episodes of Systemic and Borderline Financial
Crises mimeo, World Bank, October 1999.
Mortgage brokers, who did not have proper incentives to make sure that borrow-
ers could afford to pay back mortgages and were virtually unregulated, are now
likely to be subjected to more regulatory scrutiny. Licensing requirements for mort-
gage originators are likely to be tightened up, and more regulations will require
them to disclose mortgage terms more clearly and prevent them from encourag-
ing borrowers to take on more debt than they can afford.
Some of the complex mortgage products that were offered to subprime borrow-
ers may be banned by regulation. Even with full disclosure of these products char-
acteristics, they may still be so complicated that subprime borrowers, who are
unlikely to be financially sophisticated, cannot understand them and make
informed choices. Government ban or regulation of certain mortgage products
might help prevent subprime borrowers from getting in over their heads again
in the future.
Compensation schemes for all the parties in the chain from origination of mort-
gages to the eventual distribution of mortgage-related securities may be con-
strained by government regulation. The high fees and executive compensation
that have so outraged the public created incentives for the financial industry to
push out securities that turned out to be much more risky than advertised and
proved to be disastrous.
Regulation and supervision of financial institutions to ensure that they have
enough capital to cope with the amount of risk they take are likely to be strength-
ened. Given the risks they were taking, investment banks did not have enough
capital relative to their assets and their risky activities. Similarly the capital at AIG
was not sufficient to cover the high risk it was taking by issuing credit insurance.
Capital requirements will almost surely be beefed up for these institutions. Capital
requirements at banks are also likely to be tightened up, particularly for some of
their off-balance-sheet activities. Banks sponsoring of structured investment vehi-
cles (SIVs), which were supposedly off-balance-sheet but came back on the bal-
ance sheet once the SIVs got into trouble, indicate that some off-balance-sheet
activities should be treated as though they were on the balance sheet.
New regulations are needed to rein in privately owned government-sponsored
enterprises such as Fannie Mae and Freddie Mac in the United States. There are
four routes that the U.S. government might take here:
1. Fully privatize them by taking away their government sponsorship, thereby
removing the implicit backing for their debt.
2. Completely nationalize them by taking away their private status and make
them government agencies.
3. Leave them as privately owned government-sponsored enterprises, but
strengthen regulations to restrict the amount of risk they take and to impose
higher capital standards.
4. Leave them as privately owned government-sponsored enterprises, but force
them to shrink dramatically in size so they no longer expose taxpayers to huge
losses or pose a systemic risk to the financial system when they fail.
C H A P T E R 1 0
Economic Analysis of Financial Regulation
249
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