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Hashmall on Regulating "Too Big to Fail" Financial Institutions

By Lawrence Solum

Alison Hashmall (New York University - School of Law) has posted After the Fall: A New Framework to Regulate 'Too Big to Fail' Non-Bank Financial Institutions (New York University Law Review, Forthcoming) on SSRN. Here is the abstract:

The goal of any financial regulatory system should be to enable well-functioning markets, which includes reducing the impact and frequency of financial institution failures that cause systemic risk. Any regulatory structure, however, inevitably involves tradeoffs. A policy that effectively reduces systemic risk and its associated costs might also increase moral hazard. Similarly, a policy that seeks to reduce moral hazard and maintain market discipline - for example, by allowing a large interconnected institution such as Lehman to fail - might also create uncertainty, which can harm markets by creating panic.

In this Note I argue that our current regulatory structure is sub-optimal in its regulation of systemic risk. A different regulatory structure could do a better job of reducing the systemic risk caused by failing non-bank financial institutions while minimizing the attendant problems caused by the regulations themselves: moral hazard and uncertainty. New regulation could strike a superior balance by establishing more stringent ex ante prudential regulations of systemically important non-bank financial institutions aimed at curbing excessive risk-taking and by implementing a regulatory process to resolve the failure of such institutions. The Obama administration has proposed regulatory reform that endorses such beneficial changes, but certain details in the proposal fall short. Instead, I propose specific modifications to the administration?s proposal to produce a more optimal regulatory framework. By examining and pinpointing the strengths and weaknesses of the administration?s proposal, I formulate a regulatory framework that more effectively contains systemic risk without increasing moral hazard and while reducing excessive uncertainty caused by the regulation.

An interesting student note.

Full post as published by Legal Theory Blog on January 27, 2010 (boomark / email).