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Plausible Basis for Regulating Wall Street March 24, 2008

Posted by federalist in Finance, Regulation.

Government seems to follow any crisis with excessive attempts to regulate.  I am wary of any government interference in markets — especially in an industry like finance which has good incentives to self-regulate.  Either way, Asher Meir suggests a good analogy to guide Wall Street regulation:

There is a good reason that insurance and banks are heavily regulated. Whenever you are betting against infrequent events like floods, there is always the danger that insurers will take the money and run, and have nothing left to give customers come high water. So insurers have strict capital requirements. Some derivative strategies have similar dangers. Portfolio insurance works to insure any given investor against a market crash, but when it was adopted by huge numbers of market participants there was obviously not enough cash anywhere to indemnify the hundreds of billions of dollars of losses in the 1987 crash. We rely on banks to mediate virtually all of our financial transactions, so it is proper for regulators to ensure their soundness. Today, hedge funds supply much of the liquidity in the markets and have become in many ways bank-like entities.

Of course, hedge funds rarely trade derivatives in isolation.  Almost every transaction involves a bank-like counterparty or broker.  Brokers and exchanges are supposed to ensure that all of the contracts they trade can be fulfilled.  The last year has shown us that they don’t always do that as well as they should, so maybe more industry regulation is appropriate at the broker level.



1. federalist - January 11, 2009

NB: Regulation by government fiat is perilous. Robert Rosenkranz wrote a great essay last week explaining how laws requiring on bond ratings provoked the mortgage securities mess. Highlight:

[T]he ratings agencies are like a Consumer Reports for financial instruments — but with the force of law behind their ratings. It is as if you were forbidden by law from buying an iron or a toaster unless it is rated “Excellent.”

2. federalist - January 12, 2009
3. federalist - June 25, 2009

Rick Bookstaber continues to be one of the most sensible voices in the current debate over market regulation to avoid crises. Wall Street & Technology offers a good summary.

4. federalist - September 16, 2009

Rick Bookstaber (yes, again) explains how proper finance regulation actually protects capitalism.

5. federalist - June 17, 2010

Rick Bookstaber warns about “regulatory arbitrage.”

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