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New Research in Financial Regulation – James Kwak – The Baseline Scenario

This is a syndicated repost courtesy of The Baseline Scenario. To view original, click here. Reposted with permission.

By James Kwak

Not surprisingly, there is a great deal of interesting research being done in the area of financial institutions, systemic risk, and regulatory reform. Last week I had the pleasure of attending a workshop for junior law professors held by the Insurance Law Center of the UConn Law School, where I am a professor. The workshop featured a long list of provocative and weighty papers at various stages of completion. Here I just want to point out a few that are fully drafted and available on SSRN.

Robert Weber presented what should be the canonical paper on stress testing as applied to financial institutions, which has been going on for a while but became front-page news in 2009, during the financial crisis. He traces the history of stress testing back to its engineering roots in Renaissance Italy with, perhaps unsurprisingly, Leonardo da Vinci. Weber is critical of box-checking stress testing, but argues that stress testing  can be useful as a way of encouraging or inducing bank executives and risk managers to more closely investigate their assumptions and beliefs and ultimately create a “morality of quantitative skepticism.”

Gallons of ink have been spilled over the Orderly Resolution Authority established in Title II of the Dodd-Frank Act, generally over whether and how it would be used in a crisis. In 13 Bankers, Simon and I expressed skepticism that it would be used, for practical and political reasons. Joshua Mitts’s paper takes the novel approach of looking at how OLA affects managerial incentives in the pre-crisis period, arguing that it encourages bank executives to design their firms in such a way as to maximize the chance of a taxpayer bailout. This would lead them to increase their exposure to other large financial institutions and to increase the correlation of their asset portfolios with those of other large firms.

Mehrsa Baradaran takes a historical view in her paper, which is about the social contract between banks and society as expressed through banking regulation. She begins with the Hamilton-Jefferson debates over banks (which is also where we began 13 Bankers) and covers the history of banking regulation (or non-regulation) up to the 1930s, which represented the most thorough codification of the social contract: the government needs banks, but banks also need the government. The past few decades, however, have seen an erosion of this social contract, giving banks the benefits of government sponsorship and support without the obligations necessary to ensure that they serve societal ends. Baradaran argues that banking regulation should incorporate a robust public benefit test to ensure that banks are in fact helping households, the economy, and society at large.

There are other interesting papers that are sure to come out of this workshop. One small side benefit of the financial crisis has certainly been the increased attention to the financial sector and the risks it presents to the rest of us.

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