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After the Fall: A New Framework to Regulate 'Too Big to Fail' Non-Bank Financial Institutions

Alison Hashmall

New York University School of Law

January 23, 2010

New York University Law Review, Forthcoming

The goal of any financial regulatory system should be to enable well-functioning markets, which includes reducing the impact and frequency of financial institution failures that cause systemic risk. Any regulatory structure, however, inevitably involves tradeoffs. A policy that effectively reduces systemic risk and its associated costs might also increase moral hazard. Similarly, a policy that seeks to reduce moral hazard and maintain market discipline - for example, by allowing a large interconnected institution such as Lehman to fail - might also create uncertainty, which can harm markets by creating panic.

In this Note I argue that our current regulatory structure is sub-optimal in its regulation of systemic risk. A different regulatory structure could do a better job of reducing the systemic risk caused by failing non-bank financial institutions while minimizing the attendant problems caused by the regulations themselves: moral hazard and uncertainty. New regulation could strike a superior balance by establishing more stringent ex ante prudential regulations of systemically important non-bank financial institutions aimed at curbing excessive risk-taking and by implementing a regulatory process to resolve the failure of such institutions. The Obama administration has proposed regulatory reform that endorses such beneficial changes, but certain details in the proposal fall short. Instead, I propose specific modifications to the administration’s proposal to produce a more optimal regulatory framework. By examining and pinpointing the strengths and weaknesses of the administration’s proposal, I formulate a regulatory framework that more effectively contains systemic risk without increasing moral hazard and while reducing excessive uncertainty caused by the regulation.

Number of Pages in PDF File: 40

Keywords: Bank Regulation, Financial Institutions, Financial Regulatory Reform, Systemic Risk, Moral Hazard, Bear Stearns, Lehman

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Date posted: January 26, 2010 ; Last revised: April 20, 2010

Suggested Citation

Hashmall, Alison, After the Fall: A New Framework to Regulate 'Too Big to Fail' Non-Bank Financial Institutions (January 23, 2010). New York University Law Review, Forthcoming. Available at SSRN: http://ssrn.com/abstract=1541168 or http://dx.doi.org/10.2139/ssrn.1541168

Contact Information

Alison Hashmall (Contact Author)
New York University School of Law ( email )
40 Washington Square South
New York, NY 10012-1099
United States
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