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It’s Time to Redefine ‘Financial Regulation’

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The Exchange

By Perry Mehrling, Professor of Economics at Barnard College and Senior Economic Advisor for the Institute for New Economic Thinking

Robert Frost famously once said that "good fences make good neighbors." But when it comes to regulating the global financial markets today, one could easily conclude that the expression should be "good fences make good policy."

Everyone in the financial regulatory world wants to ringfence something. They just can't agree on what. Some want to lock the wild animals in a cage to keep them away from us; others want to lock the tame animals in a cage to keep them safe from the dangerous world outside.

The Existing Proposals

Look at the solutions offered by Sir John Vickers, head of the U.K. government panel charged with recommending reforms in methods of establishing interest rates in the wake of the Libor scandal; Erkki Liikanen, the Finnish central banker who leads a committee of economic experts who are advising the European Commission on ways to avoid another financial crisis; and Paul Volcker, whose proposed "Volcker Rule" would restrict trading activities at banks that operate with federal guarantees.

In each proposal, the idea is to have bank capital separately allocated for some risky activity and to prevent that capital from being exposed to any other risky activity.

Vickers, for example, wants to ringfence retail banking with the idea of trying to protect Main Street from the more risky activities of investment banks. Liikanen wants to ringfence all Wall Street-type trading activities within existing European universal banks, apparently in the hope of keeping the rest of the banks' activities safe from them. And Volcker simply wants to ringfence the market-making aspect of trading in order to separate it from so-called proprietary trading, which exposes bank capital to price risk.

All three proposals represent attempts to come to regulatory grips with the dramatic changes in the nature of banking over the last 30 years or so, changes laid bare to the world by the global financial crisis that began in August 2007 and continues to this day.

Time for a New Definition

My own view is that we need to begin by thinking of banking more generally as dealing. We need to distinguish between money dealers who quote buy and sell prices for funds and risk dealers who quote buy and sell prices for risk. Both of these activities need a backstop, but each needs a different kind of backstop since funding liquidity is a different thing from market liquidity. And in both cases we need to distinguish between matched-book dealing and speculative dealing.

That's essentially what Volcker is trying to do, but I probably arrive at this view in a different way than he does. The ideal of a matched book is to have offsetting risk exposures that net out exactly. If you really could do this kind of perfectly aligned swap you would not need any capital since you would be bearing no risk.

But there is one kind of risk that does not net out in this scenario: liquidity risk that is systemic. Even if all other risks net out, there's no getting around the fact that the larger the scale of the matched-book position, the larger the liquidity risk. Because of this, there is always an implicit liquidity put from matched-book dealers, both money dealers and risk dealers, to the central bank.

My thinking is that we should make that liquidity put explicit and then argue about the details, including how much it should cost.

Speculative dealing is an entirely different animal, at least conceptually. It is true that liquidity risk is involved, again in both money and risk dealing. But price risk is the big thing, so this is where you want to have capital requirements or other ways of ensuring that the taxpayer is not providing implicit capitalization.

Get Rid of the Fence

So where does that leave me in terms of the proposals on the table?

Simply put, I don't think it makes sense to try to ringfence either Main Street or Wall Street. Shadow banking brought them together—money-market funding of capital-market borrowing. And the collapse of shadow banking has torn them apart.

We could, of course, simply adopt a regulatory structure that reads that experience as the verdict of history and so strives to keep the two sides apart forevermore. My concern, however, is that maybe that is just piling on rather than constructively trying to imagine an ongoing engagement between the two, a market-based credit system that is shorn of the worst elements of the shadow-banking system.

Europe is having its Glass-Steagall moment and maybe they just have to go through it. But the U.S. has been there and done that. So I'm with Volcker that we need to try to distinguish matched-book market making from speculative position taking. The former involves liquidity risk and requires a liquidity backstop, which should be forthcoming — one possibility is to actively try to concentrate it at central clearing counterparties. The latter involves price risk and requires a capital backstop, which should be demanded by counterparties in the first place and by regulators protecting the public purse in the second place.

The beasts are already out of the cage. Maybe domestication is better than putting them, or us, back behind the fence.

By Perry Mehrling, Professor of Economics at Barnard College and Senior Economic Advisor for the Institute for New Economic Thinking