Regulating financial activities or organizations?

There seems to be two directions to travel if we want to impose regulation on how finance works. The first is an organizational solution to the problem, the second is an activity-based (and cross-organizational) solution to the problem.

The first approach, then, would impose regulation on financial services organizations. I would include a pretty wide range of organizations: commercial banks, investment banks (not that there are any of these left), hedge funds, pension funds, mutual fund (and holding) companies, private equity funds, futures trading companies, REIT funds. This is a partial list. But conceptually, it’s any organization that participates in the keeping and investing of customers’ funds, business funds, or state funds.

Some organizations are multi-headed hydras in this sense – Citigroup does all of these things and more, nationally and internationally. Goldman Sachs trades its own accounts (called proprietary trading), brokers government bonds, manages mutual funds, and manages financing for its clients (Mergers & Acquisitions, bond issuance, etc). But your local probably does more than one of these things, and your state’s pension fund does too.

This episode of This American Life captures some of the regulatory gamesmanship that happens between federal/state financial regulatory agencies and the organizations they are supposed to be overseeing.

Still, if you think the problem is that these are sprawling organizations that are too big to fail, too big to manage, too influential to be regulated, then the answer is to break them down into their constituent parts or else to regulate them all as the simplest thing – banks. This is the reason why Galbraith’s suggestion is to give over regulation of systemic risk to the FDIC: “If institutions like hedge and private equity funds are to be considered as posing systemic risks similar to banks, they can be declared to be banks, and regulated as such. Money market mutual funds, which are now subject to insurance, can be reconstituted and regulated as narrow banks…The problem of regulation will be simplified, if we recognize that the crisis presents an opportunity to simplify, restructure and downsize the entire structure financial system.”

The challenge with this approach is that financial institutions can differ pretty dramatically, while at the same time fulfilling the same financial function. So OTC derivatives traded by a pension fund are monitored differently than the same trades by a commercial bank.

The alternative approach, which is more in line with what I would want to do, is to care less about the institutional forms of financial firms and more about the activities that they engage in. For instance, in order to securitize debt it is necessary to create a new corporation to transform that debt into investor shares.

no limited liability corp, no securitization

no limited liability corp, no securitization

If we had a functioning rating system, we could use it to price these derivatives independently of the financial services organizations selling/buying them. Still, one alternative is to create an independent entity that doesn’t just slap a ‘good to go’ label on the things, but actually values them. But there remains the problem that, if a pension fund in Wisconsin needs to have a bond rated AAA in order to buy it, financial services orgs will try desperately find a way to slap a AAA rating on it (sounds like hot dog-making to me).

Or, if the SEC wanted to exceed its authority, or if we wanted to make life more difficult for financial services orgs and easier for the rest of us, we might consider disallowing these kinds of limited liability corporations. First, they are in the Caymans and other places only because tax liabilities are lower and secrecy is higher. It is just another form of regulatory arbitrage. And if there is just no possible way to structure derivatives in the US, another alternative is to simply disallow OTC derivatives altogether and have everyone trade stuff on existing exchanges. The analogy for me here is that 99% of us seem to get by with the denominations of $1, $5, $10, $20, $100, etc. It is not perfectly efficient. But the benefits of standardized, transparent commodities I think outweighs the costs to the tailored efficiency for individual firms. (this deserves its own argument, and it’s provocative: it may be the case that the public benefits of derivatives is small. Period.). The fact that Tim Geithner can say he receives letters from firms who argue they need OTC derivatives notwithstanding, we do not need them.

I don’t know how we might accomplish these goals, but at minimum, one suggestion is transparency. We ought to know who controls these limited liability corporations, what assets back them, and a plain-english translation of their values. And if that is not possible, if the only people who can accurately gauge the value of these assets are their issuing organizations, then these instruments should be disallowed.

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