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

Abstract:     
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

working papers series