The severity of this recession has stimulated calls for greatly increased regulation of the financial sector, and for changes in some of the present regulations. Some new regulations are desirable, but the type of new regulations must be in response to a recognition that regulators failed in this crisis because they did not use the authority they had to rein in some of the investor exuberance.
The claim that the crisis was due to an insufficient level of regulation is not convincing. For example, commercial banks have been more regulated than most other financial institutions, yet commercial banks performed no better than other classes of financial institutions. At the other extreme, hedge funds have been the least regulated, and on the whole they did better than most others in the financial sector. One major problem with regulations is the regulators themselves. They get caught up in the same bubble mentality as private investors and consumers. For this and other reasons, they fail to use the regulatory authority available to them. This implies that as much as possible, new regulations should more or less operate automatically rather than requiring discretionary decisions by regulators.
Many critics have blamed part of the financial crisis on the requirement that financial institutions value their assets at market prices rather than historical costs. One problem with such "mark to market" pricing that became apparent during the crisis is that it is difficult to accurately value assets in very thin markets that have few transactions. Moreover, most of the transactions that do take places are fire sales made because sellers need quick cash. In such markets, if assets are held for a while before they are sold, their value may be much higher.
One does need flexibility in using the mark to market principle, but this accounting method is most of the time a much more useful way of valuing assets than using original cost of the asset, even when adjusted for depreciation. For assets that have been held for significant periods of time may be subject to huge changes in worth that make original cost largely irrelevant.
Perhaps a useful approach (suggested to me by David Malpass) is that instead of requiring all companies to use either mark to market or cost based accounting, companies should be permitted to decide which method to use. This would add a little to the information complexity of evaluating company assets, but it would also make the accounting process more flexible. Presumably, however, companies should have to commit to one or the other accounting rules for some timee rather than being allowed to change their approach whenever they see fit.
Once we are out of this crisis but not before we are out, I believe capital requirements should be imposed on investment banks, hedge funds, and other financial institutions in the form of maximum allowable ratios of assets to capital. One major advantage of such a requirement is that it can operate rather automatically rather than requiring regulators to make discretionary choices. The extremely high leverage in many financial institutions during the past few years created a fundamental instability in the financial sector regarding its ability to respond to large negative aggregate shocks to the system rather than only individual firm idiosyncratic shocks. Limiting the ratio of assets to capital would help prevent the high leverages that contributed to the collapse of many financial institutions in the wake of the sharp falls in the values of the assets they were holding.
Capital requirements also provide a way to respond to the "too big to fail" principle when, rightly or wrongly, large firms are often kept from going bankrupt. When large financial firms get into trouble, they impose costs on everyone else both due to the repercussions on financial and other markets, and to the taxpayer monies used to bail them out to prevent their complete collapse. For example, during this crisis the sharp declines in the values of the diversified commercial bank Citigroup, and of AIG, a giant insurance company and in recent years hedge fund, imposed major costs on the system. Their collapse led to massive and continuing federal government injection of monies into these companies.
One-way to reduce the likelihood of a too-big-to fail-problem is to impose higher capital requirements relative to assets on larger financial firms. That is, to implement a progressive set of capital requirements relative to assets that would increase as the size of a bank or other financial firm increased. Since they would not be allowed to expand so much beyond their capital base, larger financial institutions would be better prepared to deal with aggregate shocks to the financial system than they were during this crisis.
Such a progressive system of capital requirements would also reduce the incentives to become large since this system would impose a "tax" on becoming big. In an environment when large firms are protected by the government from failing, and when their failure helps bring down other interconnected financial and other firms, decreased incentives to become a large financial institution are desirable because of the cost these institutions impose on everyone else.