Rethinking Financial Regulation: How Confusions Have Prevented Progress

Flawed and ineffective financial regulation fails to counter, and may exacerbate, distorted incentives within the financial system. The forces that lead to excessive fragility through unnecessary and dangerous levels of leverage, opacity, complexity and interconnectedness also distort credit markets and create other inefficiencies. In this chapter I focus on the failure to correct key flaws, which were evident in 2007-2009, in the design and implementation of capital regulations. These flaws include low equity levels, the risk-weighting system, allowing debt-like hybrids (under various titles, such as Total Loss Absorbing Capacity or TLACs) as substitutes for equity, and measurement issues, including poor accounting of risk exposures in derivatives markets and in the so-called shadow banking system. Confusions about the sources of the problems and about the tradeoffs associated with specific tools have muddled the policy debate and have allowed narrow interests and political forces to derail progress towards a safer and healthier financial system.