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Remarks on “International Exposure to U.S.-Centered Credit Market Turmoil”at the 2009 Financial Market Conference of the FRB Atlanta on “Financial Innovation & Crises”

Vincent ReinhartResident Scholar

The American Enterprise InstituteMay 13, 2009

Jekyll Island, GA

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Maps of my comments

Organizational issue

Costs of crises

Geometry of financial regulation

Cautionary note

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Thanks to the organizers…For the nonjudgmental “&” in the title

As opposed to “Financial Innovation and its Evil Spawn Crises”

Crises have almost always been with us

Unless considerable restrictions on financial flows are in place

Unlike debt or inflation crises, they are prevalent over time and across different regimes

This suggests a dynamic game between the public and private sectors

Source: Reinhart and Rogoff (2009)

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The most expensive stage of a financial crisis

IS NOT the

Initiating economic shock

Magnification in financial markets

Policy missteps Forbearance Clean-up

IS When society writes the narrative

to describe what just happenedThe narrative determines the legislative and regulatory responseThis has been done wrong before. In the 1930’s, we “learned”

Fiscal policy is effective Monetary policy is not Competition can be excessive and Trade restrictions useful

Costs include stifling innovation and making the system too complicated and vulnerable when we unlearn those lessons

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Stijn Claessens is exactly right in focusing on the lessons learned from the crisis and their consequences for regulation

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The most useful metaphor for the problem of international financial regulation was written in 1884

Gave individuality to geometric concepts

Highlighted the difficulties of perspective and projection

Consider the plight of a 2D entity visited by a 3D object

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A national financial regulator…

Is a 2D entity observing a slice of a 3D large complex financial institution (LCFI)Taken together, our global system is one in which many regulators observe different slices of the same entity

With the slices taken at oblique anglesThe failure of oversight represents the failure of imagination

To visualize a complicated object properly

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From this perspective, consider Claessens’ policy alternatives

Coordination through a “college of regulators”

Converged approach with common frameworks

International banking charter

World financial authority

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A geometric explanation…

Coordination through a “college of regulators”

Converged approach with common frameworks

International banking charter

World financial authority

Pool the visualizations

Enforce a common shape at each cross section

Invent a higher dimensioned authority

Genesis worked because God started with a void

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A cautionary note…

A LCFI arrives at its overall shape by manipulating its appearance in each national slice

Tax avoidance Regulatory arbitrage Too-big-to-fail protection

The resultant entity is Quite complex in its full dimensionality Hard to visualize at a lower dimension Quite changeable from only a small rotation

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Practical consequence of this complexity

From the outside, an LCFI Hard to regulate

Leading authorities to be more likely to protect it Hard for the market to monitor, lessening

Shareholder oversight of management Counterparty discipline Takeover threat

From the inside, an LCFI Hard for management to supervise, creating

Incentive misalignments Suitability problems Compensation abuses

In a crisis, an LCFI Less resilient and subject to sharp changes in view as

objects turn and collide

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Plea for the under-explored alternative—simplification (converged approach)

Limit the number of standard charters by function

Have holding companies hold

Why? Easier to monitor

entities in regional slices Aligns incentives better Easier to identify and

protect systemically important parts, but not the whole

More costly

But so are all the alternatives

And the most likely alternative, a utility-regulatory model—will be very costly indeed by stifling innovation

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