Five years after the Lehman Brothers collapse — and despite thousands of pages of regulation — there is widespread agreement that the global financial system still needs to be fixed. University of Chicago Booth School of Business professors have been at the forefront of proposing reforms to global banking and offer four suggestions for making the financial system safer.
In this short documentary produced by Booth, Luigi Zingales, John Cochrane, Randall Kroszner, Douglas Diamond and Anil Kashyap discuss breaking up banks, raising their capital requirements, improving regulation and creating a global authority to oversee the financial system.
Zingales, a proponent of breaking up the banks, says that though he originally supported the repeal of the Glass-Steagall Act, which separated commercial banking from investment banking, he since has reconsidered that stance.
“I thought it was a good idea to repeal [Glass-Steagall] because I didn’t see any compelling reason to put a restriction in the marketplace,” he said. “Over the years I changed my mind for a number of reasons. Paradoxically, none has to do with the financial crisis itself because I don’t think the existence of Glass-Steagall would have prevented the financial crisis.”
Zingales added that he thinks risk-taking should be separated from insured deposits, and the Volcker Rule — a recent proposed compromise that would limit retail banks from proprietary trading — is not implementable.
“I think it is important to keep somewhat separate the banking market from the capital market because when you have a crisis in one the contagion doesn’t spread to the other,” he said. “So we saw in the past, in 1987, where the stock market crash with zero impact on the banking sector. Why? Because the two were very separate.”
In 2008, though, things spread quickly, he said.
Cochrane says that rather than fixing “everything under the sun,” there is one major fix that needs to be made: Capital requirements need to be raised significantly.
“I think capital requirements should be much higher because I think banks should not fund their risky investments by run-prone assets,” he said. “They should be selling things that look a lot like stock, where if the bank loses money, you lose money.”
Cochrane added that there first needs to be agreement on how to define capital requirements. “Capital requirements is not liquidity, it’s not money set aside in case of danger,” he said. “Capital requirements is about, where do banks get the money they lend?”
Kroszner said the role of regulators needs to be adjusted to improve regulation of the financial sector.
“I think some people have said they’ve waved the magic wand of Dodd-Frank and thought, ‘All is better now’ — far from that,” he said. “There are still many, many issues outstanding, even in Dodd-Frank. So a lot of my proposals involve a much more engaged role for regulators.”
Kroszner said that regulators should be looking at risks, rather than trying to enforce particular laws.
“I worry that what a lot of what Dodd-Frank has done is set up these lines that give very strong incentives to try to get around, and so the regulators and supervisors spend their time trying to focus on narrow compliance rather than the substantive risks,” he added.
Building on the idea of improved regulation, Kashyap and Diamond argue for the need for a global authority that is charged with coming up with rules for how to deal with winding up failing banks that often have operations in multiple countries. That, though, is easier said than done.
“We’re not really much closer to solving the fundamental problem than we were, but … tactically we’re much better since the U.S. passed the Dodd-Frank bill because we have regulators who are tasked with the job of looking out for these crises,” Diamond said. “The biggest problem is that most of the runs on the banks were on banks that had many international divisions, and Dodd-Frank doesn’t do anything about resolving such complicated institutions. And we need to do something like that, but I have my doubts that we’ll be able to do anything like that on an international scale.”
Kashyap said that there is nothing that can eliminate financial crises permanently.
“Having resolution authority that will work across borders would be a good thing to make them less of a problem, but it wouldn’t make them go away,” he said. “What the regulators are trying to do instead is use changes in the capital structure of the banks to make it easier to fail an institution. So, for instance, if you have a lot of debt that converts to equity, well then you buy time to try to arrange a sale because instead of selling a gone concern, you can try to sell a going concern.”
The proposals are not great, but they are better than what we had in 2008, Kashyap said.
For more information, watch the mini-documentary on the Capital Ideas YouTube page or read the full article on the Capital Ideas website.