Towards an Alternative Regulatory Culture

Ideas for fixing Dodd-Frank when the time comes

It can be very hard to break trends. Just ask the Chicago Cub’s and their lack of World Series wins. Trying to reform the firmly established mental framework for financial regulation in the United States and rest of the world has proved no easier a task.

If there were to be some catastrophic event to highlight the folly of a decades-long addiction to dependence on regulatory perfection, and buck the system, the financial crisis would have been it. But even the near collapse of the banking industry-as governed by some of the tightest, most detailed regulations in history-and subsequent recession haven’t been strong enough to usher in the radical reforms necessary to put the market on a stable and sustainable growth track.

Nearly everyone agrees that regulatory failure played a significant role in causing the crisis. Consensus breaks down in agreement on exactly how it failed. The prevailing view guiding policymakers goes something like this: Regulatory policies for managing mortgage underwriting and high frequency trading were too loose; rules defining capital adequacy requirements set too low and leverage allowed to rise too high; and limits in derivatives trading and executive compensation were simply nonexistent.

As with all great misunderstandings, there are strains of truth in this narrative-some very prominent strains in fact. For example, there is no doubt that underwriting standards were one of the top causes of the spread in toxic debt.

The natural conclusion then would be to tighten, expand, and add regulations where necessary. Which is precisely what the Obama administration and Dodd-Frank Act has set out to do.

However, this perspective suffers from a severely debilitating flaw. Regulatory failure was much more than an absence of rules to prevent a catastrophic meltdown. The failure was the mental framework and structure for writing regulations itself.

The current system is based on a negative strategy: find risky activities and stop them, find practices that have tripped up consumers and stop them. Inherently, this model cannot adapt well to changes in the financial market. As new products, businesses, and technologies are developed, there is no flexibility with in the laws to prevent new risky activities associated with innovation.

A positive strategy for regulation of the financial sector would not focus on limiting specific actions in the marketplace, but establishing rules that would give incentives to market participants to manage their risk better by themselves. Such a system would be able to absorb changes in the marketplace because bankers and investors would have the same incentives to manage their resources and reputations prudently. As such, regulators wouldn’t have to worry about their inability to keep pace with financial innovation.

The distinction between a simple failure of a bad or missing rule, as opposed to a failure of the negative model for the regulatory structure itself, is significant. If the former were to hold true, the it would make sense to just adjust rules and laws as necessary, like we are doing now. But if the later can be shown, then a wholesale change in the psychology of financial services regulation would be necessary.

Structure Problem: Incentives

Looking at the structure of regulation, it becomes evident very quickly that the whole framework will need to change, and that mere adjustments of the status quo-which is all that reforms like the new Basel III agreement really amount to-will not bring sustainable economic stability.

The old regulatory rules placed too much faith cult academic superiority-largely the Alan Greenspan team at the Fed-and were designed with too much dependence on regulators to prevent systemic collapse. The structure certainly had the fingerprints of good intentions all over it. For example, the Basel rules were based on a very reasonable and logical framework for protecting banks from over leveraging while also trying to avoid being overly restrictive. Yet, the best laid plans failed to anticipate how American banks could manipulate the rules to reduce the capital requirement on the exactly same mortgage from 8 percent to 2 percent simply by packaging it up with other (ultimately toxic) debt and getting a government-guarantee from Fannie Mae or Freddie Mac slapped on it.

On the flipside, there were parts of the system that weren’t so well intentioned. Many of the agreed upon prudential standards were the product of regulatory capture-not some objectively developed means of defining safety (not that one could be perfectly created anyway). The past few decades were hardly the great era of deregulation that Paul Krugman and his ilk like claim. But the legislation that was passed to enhance market freedom (at the behest of the financial industry) did have some unintended consequences, since banks were incentivized to abuse their new freedoms instead of embracing them prudently. It wasn’t the removal of regulations-the financial system remained right up through the crisis the most intensively regulated industry in the country. Rather, it was the way deregulation was pursued.

Certain “deregulatory” measures were undertaken without the comprehensive changes needed to avoid financial institutions from abusing the new freedoms via their too big to fail status. The Gramm-Leach-Bliley Act justly struck down restrictions on the use of capital for whatever purpose a bank might want to pursue, which is a positive defense of property rights. However, the legislation failed to realize that a combination of deposit-insurance, poorly designed tax laws, and history of bailouts had created a culture of too-big-to-fail (TBTF), which actually worked to encourage risk taking. The act of ending Glass-Steagall itself wasn’t a problem, but not finishing the regulatory reform job was. Only when there is a well-established capacity to fail can free enterprise truly flourish.

In this sense, the too big to fail problem is one of the most deadly for a market system. Without TBTF, the financial culture would have been (and could be) far more prudent, since bank resources would’ve been on the line. Without TBTF, debt and equity holders would have had (and could have) cause for stronger due diligence. Without TBTF, bankers would have had (and could have) more incentives for properly aligning their risk appetite.

Changing the way we think about financial regulation completely alters the approach to today’s biggest concerns. Going back to the Basel example, the core problem wasn’t that the rates defining capital adequacy were too lower-although they were. The problem was that the whole design structure of detailed but arbitrary rules didn’t properly align the incentives of bankers to manage their own risk. Combined with the culture of TBTF, bankers used the Basel rules not as a minimum standard for safety, but as a mere limitation unlinked to any non-arbitrary measure of risk to try and find ways around.

If the structure were okay, then raising the capital requirement levels makes sense. Although they still depend on risk-weights that are subjective, overly rely on central bankers to determine when to increase rates from a base standard to a buffer level, and likely wasn’t set high enough since the rate was reached via political compromise. However, the structural basis for Basel isn’t okay since it focuses on using a very detailed set of rules for banking capital adequacy instead of trying to give banks the incentives to self-govern their own capital levels as they-and their investors-see fit.

Limited Knowledge

Another problem with the new Basel rules-which German banking regulatory president Jochen Sanio calls Basel 2.5 since it uses the old framework and just updates the definitions of the capital along with higher rates-is that they are dependent on central bankers knowing when to trigger certain requirements for more or less capital kept in reserve. The baseline for banks has been increased to 4.5 percent. However, banks may be required to keep up to 2.5 percent more in reserve during good times as a “buffer.” When economies turn sour, each nation’s central bank will determine on its own whether or not to allow banks to use their capital buffer.

This process will undeniably be politically influenced, but moreover, central bankers simply cannot know exactly when to require these trigger points. We have ample evidence that the Federal Reserve isn’t up the challenge by their failure to manage the federal funds rate. In the wake of the dot-com bubble the Fed left interest rates too low for too long, and then didn’t cut them fast enough as the subprime crisis set it. Furthermore, the Fed has been on record numerous times saying it can not predict bubbles-so it is unlikely they will be able to predict the best times for banks to keep or use their capital buffers.

This is not to say we shouldn’t have a central bank. Nor is it intended to disparage the intelligence of regulators. The simple fact is that whether regulators or not-we all have limited knowledge. Furthermore, no matter how much knowledge the staff at regulatory agencies develop they can never have perfect knowledge. There simply are too many moving pieces in the economy.

As such, we should not expect regulators to have perfect knowledge or expect their agencies to act as the saviors of the market. Or design systems that require that they do. Bearing this in mind will change the way we look at particular proposals for reform, such as depending on regulators to trigger increases in the Basel capital requirements.

Of course, the political feasibility of changing the structure of the new Basel agreement would be very hard to change. There is very little trust among central bankers on the international level that someone will undercut them. And getting the deal finished that was agreed too was hard enough.

Similarly, reversing many of the new rules being drafted and implemented as a part of the Dodd-Frank reforms will take time and immense political capital.

This presents a challenge to a comprehensive reform of the financial services regulatory system. And comprehensive change is necessary. The less capacity a bank has to fail, and the more taxpayer money is on the line, the more a responsible government will be forced to try and guide the market with negatively focused rules. We can’t just deregulate the market a la carte and hope for the best.

Thinking for the Future

Still political complacency is likely to rule the day in the near-term. And this is certain to lead to future recessions and even another banking crisis since dependence on regulatory foresight to manage all risk is a failed venture. Therefore academics, financial analysts, and policymakers will need to start now in figuring out how the financial regulatory apparatus can be changed.

Agreeing on the end goal of a regulatory framework is the first step. Many of the economic reforms proposed today are focused on getting growth moving again quickly. But fast growth shouldn’t be the main focus. Rather, our end goal should be stable and sustainable economic growth. Rapid growth is certainly enjoyable-but not if it comes at the expense of stability. Pro-cyclical policies, those that that promote a boom-and-bust economy like we have today, only benefit those engaging in high-stakes arbitrage.

Therefore, any public policy aimed at fixing things in the short-term-for political purposes, because unemployment is high, or otherwise-that is unsustainable in the long-term should be rejected. Any policies that are countercyclical and focused on sustainability should be up for consideration.

The question becomes, what can regulation do to promote a sound economy with stable and sustainable growth?

Well, it may not be simple. However, this one guiding principle for financial regulatory reform, using the law to protect property rights, does lead to a whole range of changes that would create a much sounder economic foundation.

A lot has been written on property rights over the years, and it is now viewed by many as a somewhat arcane and nebulous notion that belongs in philosophical debate rather than as a guide for public policy. But it has far reaching potential in the debate over financial regulatory reform.

Underlying the principle of protecting property rights in this conversation is a belief is that individuals and investors, boutique funds and private equity groups, and corporations should all have a right to use their capital in the most productive way they see fit, so long as they don’t interfere with other’s use of capital.

Furthermore, there should be no involuntary coercion-whether in the form of regulatory limitations on certain capital uses or taxpayer funded subsidies-of this market towards favored goods or investments. Put another way: financial institutions should have the right to innovate and operate without federal bureaucrats telling them how to or how not to run their businesses. Undergirding all of this, however, is the understanding that anyone who decides to engage the financial market must understand the risks associated with doing so.

Peruvian economist Hernando de Soto has been a leading academic showing how capital itself is a pillar of any successful economy. In his seminal work, Mystery of Capital, he points out that when property rights are absent in an economy, so to is economic growth. Extrapolated from this, and other, research is the hypothesis that the more free a market is to using capital the more stable the economy. Hong Kong has often been pointed to as an example of how economic freedom, and ubiquitous property rights have lead to a thriving economy for small businesses and corporations.

But economic freedom in support of property rights doesn’t mean complete deregulation or the elimination of government. On the contrary, a sound regulatory framework is necessary to protect property rights, particularly in ensuring the capacity for businesses to fail in a stable manner. Ensuring businesses do not defraud their consumers-protecting the rights of individuals and investors-is also a vital regulatory role in the defense of property rights.

Partial respect for property rights, which is what we have the current marketplace, may be enough to create short-term growth. But restrictions on the use of capital-or public policies that try to direct the use of capital through some sort of government subsidy, no matter the good intentions-eventually will require a correction in the market. Generally correction in the form of a recession.

The Property Protection Framework

In order to avoid these recessionary corrections, financial regulatory policy should look to be increasing respectful of property rights as a guiding principle.

Unfortunately, regulatory reform has done just the opposite by putting arbitrary limits on the use of capital through derivative limitations, the preservation of a too-big-to-fail culture, and a modified Volcker Rule, among other initiatives.

The derivatives trading limitations, as well as proprietary (prop) trading restrictions, executive compensation caps, new reporting requirements for the “shadow banking” sector, were championed under the belief that they caused the financial crisis. However, none of these things-derivatives trading, prop trading, executive pay, or shadow banking-inherently were problematic.

Rather, the incentives to take risks created by a too-big-to-fail culture and unintended consequences from the host of regulations that governed financial trading were the primary cause. (Housing policy manipulations, monetary policy failure, and borrower irresponsibility were also primary causes, but outside the scope of this essay.)

Taking derivatives trading as an example, the Dodd-Frank rules are largely an attempt to avoid another colossal failure like AIG, which had built up an unsustainable portfolio of risky credit default swap (CDS) contracts. The assumption was that the financial product themselves were inherently problematic. However, it was the incentive structure of AIG that led to risky business practices. Had AIG feared for its financial future, CDSes would never have been a problem in the first place.

Enter the property rights protection principle. There certainly is need for regulatory reform when it comes to derivatives, but the answer is not what Dodd-Frank has designed. The central plank in the new derivatives rules is a requirement that nearly all trades be done through a clearinghouse on an open exchange (auto companies and corporate end-users are exempted). Financial institutions must also make most of their derivatives trades from separate, non-deposit funded subsidiaries to reduce the risk. And those wishing to initiate derivative contracts have to meet higher capital requirements, especially if they want to create customized derivatives away from the exchanges, which will entail significantly higher margin standards and costs to discourage excessive risk taking use of non-standardized products.

All of this is unnecessary attack on the property rights of derivatives traders that curbs the ability of owners of capital to make productive use of what they own. Beyond the fixing the too-big-to-fail problem that doomed AIG (which is addressed next), the real problem that developed over the past decade was a lack of transparency that made it very difficult for investors with limited resources to perform effective due diligence when engaging in derivatives trading. But unlike the Dodd-Frank rules, regulation could easily achieve the goal of transparency without violating property rights.

I would purpose allowing financial institutions and others to continue trading as they see fit-it is their own capital after all-but be required to report their trades to a centralized regulating agency. The regulator would collect this information and display it publicly, at regular intervals, in effect providing transparency to the market without restricting any trades. The regulator could design reporting standards that make it easier to process information, but wouldn’t have to standardize contracts themselves, as the Commodities Futures Trading Commission is presently doing.

Under this reporting mechanism if a particular institution were taking on too much risk, the market would see it and react accordingly, avoiding systemic risk. AIG would never have built up so much CDS risk if the market had seen the problem developing. And in the case that the market decided to continue trading with AIG anyway, there would be a better sense at AIG for their own risk (which they were not aware of themselves) and fair warning to any willing to take the risks.

In this way, regulation can help the market monitor itself without restricting financial innovation or property rights. However, it still leaves the concern over an institution becoming too-big-to-fail by taking on excessive risk. This leads to another way that regulation can help the market protect property rights and maintain stability: providing an objective process for managing financial failure.

An Objective End to Too Big to Fail

In the U.S. we have a well-established bankruptcy code that works pretty well with the exception of resolving very large institutions. The so-called too-big-to-fail financial institutions. But for the change in mental framework for regulating the financial sector to ultimately be effective, the concept of too big to fail must end. Leaving this in place is the single greatest reason claims that “deregulation caused the crisis” are so prevalent today.

Ending TBTF has been the stated goal of policymakers around the world in the wake of the financial crisis. However, Dodd-Frank leaves the moral hazard of too big to fail in place by establishing a bailout fund and a resolution process based on subjective decisions by regulators that will always be manipulated by political pressure. And two months after President Obama signed the Dodd-Frank law, regulators gave a $30 billion guarantee to bailout wholesale credit unions that threatened to take down the whole credit union network. In Europe, the potential sovereign debt default from Greece and Spain threatening European banks and the Euro itself lead to the creation of a frankly named “rescue fund.”

Too big to fail is very much alive today. But, for the market to be stable and sustainable, and for economic freedom to flourish, the right to succeed must be accompanied by the capacity to fail.

A principle right in owning capital is to the profits from the productive use of that capital. But the corollary is that owners of capital must also accept negative consequences if their use of property is unproductive. As such, one of the most important roles regulation should play is to clearly outline, in objective fashion, the consequences of failure. And regulators should have little power to do anything other than enforce those pre-established rules.

The goal of regulation in preventing TBTF should be to align the incentives of financial institutions so that they bear responsibility for their own risk taking and to have a clear and objective process for dealing with fraud and failure. There a lot of ways this can be done, but three ideas would be to establish living wills, require “bail-in” capitalization, and fixing the tax code.

First, financial institutions should develop “living wills” that outline exactly how they could be liquidated in the case of insolvency. In order to avoid executives from writing their own funeral in a way that inappropriately benefits themselves, these living wills should be reviewed and approved through an objective process by a regulator. And in fact, Dodd-Frank includes provisions that require living wills.

However, the new regulatory reform requires that a regulatory agency-the Federal Deposit Insurance Corporation-to take over a failed institution to execute the will. This requires the government to temporarily take on the liabilities of the failed business, in theory putting taxpayers at risk. Dodd-Frank mitigates this process by establishing a bailout fund (paid for by the banks) and requiring any additional losses be paid for by the remaining healthy banks.

The principle problem with this approach is that the property rights of healthy banks are put at risk. Why should successful financial institutions have to pay for the failure of a competitor? This creates seriously distorted incentives when it comes to competition, but moreover does not respect property rights.

Instead, we should change the bankruptcy code in a number of substantial ways. The judiciary should establish a series of courts with judges who have received adequate financial training so that they can expedite their meditation of a bankruptcy procedure. The process should also be sped up-what some academics are calling “speed bankruptcy”-so that counterparties are not left questioning what they will get out of the liquidation. The exact details of how this would look are yet to be fully fleshed out in the economic literature, but is being developed.

An important part of a living will would be using a “bail-in” process to aid the speed bankruptcy process. One of the critiques of living wills is that even they don’t move fast enough, as the resolution of insolvent banks is most preferably done over a weekend at worst. Many have advocated instead for convertible bonds, where debt would be converted to equity overnight in an orderly process to keep a financial institution operating to meet its liabilities. Lenders would understand exactly at what point their debt would be converted to equity based on pre-established guidelines. I believe that bail-ins can be a part of a living will, and likely should be included at least to some degree. However, financial institutions should not be required to raise all of their debt in the form of convertible bonds if they don’t want to.

Second, there need to be changes in the compensation practices at financial institutions. One of the major proponents of the too big to fail system is the lack of accountability for those taking risks. Even if firms were allowed to fail, their staff may walk away with financial damage. And it has been well documented that the compensation practices at Wall Street firms promoted a risk-taking environment, particularly with mortgage origination and securitization.

To date, most of the compensation practice reforms have focused on restricting bonuses or eliminating “golden parachutes,” however, these types of initiatives infringe on the rights of financial institutions to pay their employees how they want to. There is no justifiable way that Washington could set a cap on pay, as any figure would just be an arbitrary limit that would curb competition.

Instead, regulation can help to align the incentives of senior executives to closely monitor risk taking and ensure prudent business practices. Financial journalist William Cohen wrote for The New York Times that compensation practices at Goldman Sachs are an example of how to make sure staff are hyper focused on being profitable and excessively risk adverse. Since going public in 1999, Goldman has paid its top several hundred executives from the firm’s pretax profits, instead of gross revenues. Without any pretax profits, there are no bonuses in the tens of millions as are counted on each year. “This may very well be the precise reason that Goldman alone saw the brewing mortgage meltdown and did something about it,” Cohen writes.

Essentially, the idea is for companies to act more like they did when partnership models governed Wall Street firms, creating a sense of ownership from the senior leaders. This means using regulation as an accountability tool. One proposal, from Cohen, would be to make the top executives in financial institutions personally liable for the risks they take, putting their stocks, paycheck, and even personal property on the line. Such a requirement wouldn’t be anti-free market or even violate the principle of protecting property rights.

While firms have the right to pay their employees how they want to, there is no right to work on Wall Street. And there are other professions where employees put their personal wealth at stake if they are grossly negligent of their duties, such as doctors. No one forces a doctor to perform brain surgery, and even if he fails in a procedure he is not necessarily liable for damages. But if the doctor was not paying attention to the risk he took and mismanaged the operation, then the justice system provides loved ones a legal recourse over the surgeon.

A similar model could be created for Wall Street executives to provide an incentive for those taking risks, to avoid over leveraging their firm or making excessively dangerous bets. Having the net worth of senior executives be the first inline to take losses if a firm begins to stumble would also encourage firms to develop their own risk-adverse compensation practices like Goldman Sachs, without the government telling those businesses exactly how to pay their employees.

Third, changing the tax code to incentivize due diligence is likely to decrease inappropriate risk taking. The tax code currently favors debt financing over equity financing, a problem that has not only led to decreased numbers of equity holders, who have a greater incentive to voice their concerns in the way a bank operates, but also led to the build up in leverage. A report from the IMF in 2009 found that allowing interest payments as a deduction against corporate income tax, but not the cost of equity finance, was a source of financial instability. Furthermore, the ability to manipulate the convoluted tax laws in the US also incentivized complex financial arrangements in the lead up to the crisis.

Making these and other changes would make a significant dent in the too-big-to-fail problem, and help prevent confidence crises from making market concerns self-fulfilling prophecies, as occurred starting in 2007 with the credit crunch and subprime crisis. However, the size of financial institutions remains a concern for many policymakers and market analysts.

Naturally Narrow Banking

Other critics of too-big-to-fail banks have argued that the best course of action would be to break them up. Whether by returning to Glass-Steagall separation of commercial and investment banks, or through the restriction of proprietary trading-embedded in the Dodd-Frank Act and known as the Volker Rule-there is no way to split up banks forcibly without violating the property rights principle.

This is not to say banks should remain large. As a matter of theory, the banks are too large and interconnected. They have grown that way only because of regulatory failure and certainly would not have taken on their current shapes without a system that didn’t allow them to fail. The question is how to split them up without violating the rule of law.

I believe this can be done by rolling back federally provided subsidies to the market that would lead banks to naturally break off some of their activities, curbing the size of firms. Specifically, I suggest ending the federal deposit insurance program.

The Federal Deposit Insurance Corporation has been one of the most popular regulatory agencies around since its creation in 1933, and has been credited with stopping the 150-year cycle of bank runs in America. The recent run on Washington Mutual notwithstanding, the FDIC has been largely successful in achieving its goal. However, this has come at a cost of creating a subsidized moral hazard for banks.

While banks do pay for FDIC insurance, the cost is much lower than if provided by the private market. The FDIC has a guaranteed line to the Treasury Department if its fund is depleted. While this was seen as an one-in-a-million event, the financial crisis has caused the failure of hundreds in banks in the past four years and recently pushed the FDIC fund into the red (though as of this writing the Treasury has not yet had to bailout the deposit insurance fund).

Though the FDIC has been vocal about wanting to protect its fund and ensure it has the cash to not only protect deposit accounts but also finance the resolution of insolvent banks, the Treasury bailout guarantee means banks aren’t going to be charged at the same rate as they would seeking private deposit insurance.

As a result of this subsidized insurance, customers have no incentive to think critically when considering where they put their deposits. Any deposit-bearing institution will work, depending on location and services offered. But if there were no federally subsidized insurance, customers would have to be careful where they put their deposits. If Bank of America was engaged in high level risk taking with its customers deposits, then customers might turn to a more risk-adverse bank like BB&T.

Ending the FDIC would overnight change the incentive structure around deposits and risk-taking at hybrid commercial-investment banks-the too large and complex to fail financial institutions at the top of American finance today. Customers would either pull their deposits, leaving the large banks as mainly investment banks without direct ties to Main Street, or the investment arms of the TBTF banks would curtail their risk taking.

One potential outcome could be the emergence of naturally forming narrow banking, with entrepreneurs starting new banks and marketing them as removed from the risk taking culture of Wall Street. These banks could go back to the low but consistently stable profitability of offering simple deposit and savings accounts, while making unsecuritized local loans. Meanwhile, for those that wanted to exchange the nationwide convenience of Chase bank or Wachovia branches could take a risk with their deposits that the investment parents, JP Morgan and Wells Fargo respectively, would not become insolvent from excessive risk induced losses.

Ending the FDIC could have the effect of naturally separating some commercial and investment banking, but without violating property rights or depending on regulators to know exactly how to break up banks.

Regulation to Prevent Fraud

There is one more important area regulation can help the market, and it’s far from trivial: Regulation should protect investors and consumers from fraud. The property rights principle says that businesses should be able to invest and operate however they desire, but only so far as they do not defraud their customers, deal deceptively with investors, or acting maliciously, with physical intimidation, towards competitors. Providing a justice system is exactly within the roles of government outlined in the U.S. constitution and natural law theory.

The balance in protection is tenuous. Some believe that stopping certain business practices, restricting products, or forcing businesses to communicate in a specific manner constitutions protection. However, these types of regulations very clearly violate the property rights principle.

As an example it is certainly good for consumers to understand fully the financial products they use. And the disclosure language that comes with a credit card is often in fine print and confusing. However, the reason for the detailed language stems from attempts by consumer protection advocates to use often frivolous lawsuits to attack businesses. There is a good reason for the language.

At the same time, there is a measure of competition that can be leveraged here. If there really is a demand for easier to understand credit card applications or bills, then certain companies can develop better information bulletins as a competitive advantage. But trying to force companies to communicate in a certain way to their customers as determined by a regulator that is less than omniscient is only a stepping stone to more and more invasive restrictions and violates the property rights principle.

Mortgage products have been another financial tool under fire in the housing market induced recession. Certain consumer advocates have talked of forbidding certain mortgages-such as interest only loans-or ending the practice of securitization all together. But this would be a serious invasion of property rights by telling businesses how to operate. If a product is dangerous-like a lead based toy-then consumers won’t buy it, and companies won’t offer it for fear of hurting their reputations.

At the same time, regulation can be used to help certain consumers avoid products they don’t understand. While everyone has a right to own a home if they have the capital to purchase or build one, no one has a right to financing or a right to a mortgage. One of the problems during the housing boom was that individuals and families were buying homes and taking out mortgages that were well beyond their means with little cash down and only a limited understanding of the responsibilities of homeownership. As such, it would be perfectly reasonable for regulators to design a simple test for consumers who want to take out a loan to buy a home but put little money down on that home.

A series of tests could be designed, with difficulty depending on the percentage of down payment, to assess a borrowers understanding of home ownership, just as the government uses tests to ensure a driver has the proper understanding for how to operate a motor vehicle. Anyone can buy a car if they have the money, but the law does restrict who is allowed to drive on public roads putting others in danger.

In this way, regulation can help protect consumers-particularly those who have paid their mortgages but been hurt by neighbors foreclosing, bringing down property values-but without restricting any specific mortgage products. The only invasion of business practice would be the requirement for lenders to confirm the borrower met the legal requirements for lending, just as weapons dealers are required to submit background checks before selling a handgun.

In addition, there should be well-established legal procedures for dealing with fraud when it can be found and proved. This is an important role of the SEC and state prosecutors. Only with a well-founded justice system will businesses have the incentive to operate fairly in a competitive environment. And regulators tasked with providing this service should have all the power and resources necessary to monitor and prosecute those who violate the law.


The principle of protecting property rights may not be in the mainstream of financial services regulatory reform yet, but when the current system fails us again-whether in the next two or ten years-it should be seriously considered as an alternative means of governing the financial sector in order to promote a stable and sustainable economy.

Designing a system that depends on regulators to be all knowing is a receipt for failure and continuing cycles of recession-boom-recession. The new framework should end the era of micromanaging business practices like derivatives trading, and put a stop to the micromanaging of banks like Basel capital adequacy rules. Critically, it should establish objective procedures for dealing with failure and attack the too big to fail problem by ending deposit insurance programs, finding ways to incentivize due diligence from equity holders, and ensuring risk-adverse compensation practices.

There are plenty of other ways that this different framework for regulation would have an impact, including monetary policy (though that is outside the scope of this essay). And there are plenty of ideas that could be developed to help promote a stable and sustainable economy without violating property rights. But in the end acting sooner than later to wean financial institutions-and other companies-from their dependency on government subsidies or bailouts is the only way to prevent painful readjustments in the future.