What If Striking a Balance with Traditional Regulation Isn't Possible?

This is a combination and extension of posts on my private blog from February 16th and April 9th, 2009.

A common concern in devising financial regulation is that you want to make it comprehensive enough to cover future instruments that may be developed and to eliminate loopholes, while not destroying the opportunity for innovation. By grouping financial instruments by similarity of principles you can make some broad generalizations, but since investors are extremely adept at exploiting loopholes, I think this approach is doomed. Clamp down to cover all contingencies and you stifle innovation, ease up and the loopholes undermine your original intent. Since it's so difficult, I decided to explore the situation where one assumes that it is in fact impossible and then see where that led in devising a regulatory framework. What follows is one possible approach.

Those mechanisms that have a proven track record and are well understood can have tailor made controls, but I'm constrained by my working premise from specifying controls on less well established financial instruments. That being the case, I have no choice but to concentrate on limiting their potential for damage. One way to do that is to require that unregulated investments be backstopped by holdings in the regulated sphere. This is similar in spirit to the capital requirements imposed on banks now and guarantees that even if things blow up the bulk of the market will not be crippled. Completely exempting some instruments from oversight may seem extreme, but remember the working premise is that this is effectively what occurs anyway via loopholes. Over time new innovations that are fully explored and have well developed track records can have appropriate regulation crafted for them, not only removing the backstopping requirement, but allowing them to backstop other unproven investments.

The incentives for firms is changed under this arrangement. Rather than trying to come up with opaque ways around existing regulations, there is benefit to providing a clear theoretical explanation and real world data for new inventions in order to expedite their regulation and official sanction. Obviously companies could attempt to evade the backstopping requirement by hiding economic activity, but since that's theoretically a way to evade any system of regulation I'm not going to explore it specifically.

There is a practical advantage to having a specific ratio of regulated to unregulated assets as it's an easily manipulated parameter that can be changed with market conditions. Compare this to the current system: having congress change whole regulation systems in very specific and involved ways. Usually, small changes are introduced as complete overhauls are too difficult to achieve, leading to a patchwork of complicated laws that are onerous to comply with, have unintended consequences, and leave plenty of loopholes. If the Fed were in control of the ratio (perhaps within certain limits without congressional authorization), it could provide another powerful tool for fine tuning regulatory requirements as well as adapting to changes in the economic situation.