What to do

Megan McArdle ponders.  I’ll again mention one suggestion: make sure that financial institutions cannot use off-balance sheet activity to escape standard capital requirements.  Many people asked about this in the comments but my view is simple:

1. As long as the Fed and Treasury are providing a safety net, insisting on capital requirements is entirely reasonable and it lowers moral hazard.  If you’re going to bail out your friend in a poker game, you can ask him not to bet too much beyond his chips.

2. When the "shadow banking system" does not have capital requirements, normal financial activities, as regulated by the Fed, are inefficiently taxed and too much of an economy’s leverage ends up in the unregulated shadow banking sector. 

3. If you are anti-regulation on this issue, make the capital requirement relatively low but still impose it symmetrically across financial sectors.

4. Ideally capital requirements should be adjusted for risk.  That probably implies higher capital requirements for shadow banking activity, not lower requirements.

5. Regulatory issues aside, market participants are less sure of themselves in the shadow banking sector.  Derivatives are non-transparent, for a start.  That’s another reason not to push too much financial activity into the shadow banking sector.

6. A final solution to excess risk-taking and leverage has to come from shareholders; regulation can only do so much and of course capital requirements are only a small part of regulation.  But in the meantime I think the case for more symmetric capital requirements is a strong one, recognizing all the usual comments about horses and barn doors, etc.


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