NYU Stern: November 2010 Archives

by Matthew Richardson

I am all for free markets and not mucking them up with government intervention. But the economic theory of regulation tells us that if there is a market failure, it cannot be resolved privately. The public sector must get involved.

The most illustrative examples of such failures in U.S. financial markets were the frequent financial panics from the 1850s until the Great Depression. Those episodes taught us that when illiquid, asset holdings (e.g., loans) of the financial sector are financed short-term (e.g., by deposits), and are hit by a severe macroeconomic downturn, failures of financial firms can lead to system-wide runs on deposits. This in turn leads to a massive disruption of the system that provides credit to households and corporations. When economists bandy about the term systemic risk, this is the type of event they are referring to.

The market failure here is that, although each financial institution may have been behaving optimally on an individual basis, the firm had no incentive to take into account the effect of their actions on the system as a whole. In economics, we call this a negative externality and it is analogous to an industrial firm causing pollution. In the example above, financial failure of one bank increased the possibility of runs on other banks, leading to the system-wide collapse.

Read the full opinion editorial on Big Think.com.

Make way for Trichet bonds

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by Roy C. Smith

Difficulty in resolving the debt problems of its weaker states is edging the eurozone ever closer to the brink. Even after the announcement last May of an EU/IMF €750bn sovereign loan support programme, together with appropriate budget-tightening efforts, Greek bonds still trade at around record levels over German bunds of 895 basis points, with Ireland (565) and Portugal (425).

One reason may be that too many investors see the EU as just papering over the problems, while the difficulties with the Germans may be greater than meet the eye.

Upset over the apparent violation of the no-bailout provisions of the Maastricht Treaty, and under strong political pressure, Germany might declare the sovereign support plan to be unconstitutional, forcing it out of the deal and sending everything over the cliff.

Germany does not want to spoil everything, of course, so chancellor Angela Merkel has sought to persuade European leaders to create a new permanent debt resolution treaty to handle eurozone countries with too much debt. We know how hard this is to do from the recent American experience in trying to create an "orderly resolution" process for troubled banks. The task of writing a workable new treaty that 27 sovereign countries would sign is far more difficult; perhaps impossible.

What is needed instead is a market-based solution to reduce the amount of sovereign debt among the weaker eurozone countries and to ease investor concerns. Such a solution necessarily involves restructuring existing debt through an exchange of old debt for new, lower-cost, longer-maturity bonds.

Read the full opinion editorial on EFinancialNews.com.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 is widely described as the most ambitious and far-reaching overhaul of financial regulation since the 1930s. Together with other regulatory reforms introduced by the Securities and Exchange Commission (SEC), the Federal Reserve (Fed) and other regulators in the United States and Europe, it is going to alter the structure of financial markets in profound ways. In this presentation (based on the book Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance), Viral Acharya provides an overall assessment of the Act in three different ways: from first principles in terms of how economic theory suggests we should regulate the financial sector; in a comparative manner;€“ relating the proposed reforms to those that were undertaken in the 1930s following the Great Depression; and, finally, how the proposed reforms would have fared in preventing and dealing with the crisis of 2007-2009 had they been in place at the time.

Download the presentation (PDF format)

Don't turn back on financial reform

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The Republicans, harried by their Tea Party wing, have a choice on financial reform. They can either try fundamentally to rewrite the Dodd-Frank act, or can settle for ensuring that the regulators implement it sensibly while they focus on reforming Fannie Mae and Freddie Mac. The second option is better, writes John Gapper in the Financial Times. The opinion editorial includes comments from Regulating Wall Street co-editor Viral Acharya.

Read the full opinion editorial on the Financial Times website. 

About RegulatingWallStreet.com

The Dodd-Frank Act, signed into law in July 2010, represented the most significant and controversial overhaul of the U.S. financial regulatory system since the Great Depression. Forty NYU Stern faculty, including editors Viral V. Acharya, Thomas F. Cooley, Matthew P. Richardson, and Ingo Walter, provide a definitive analysis of the Act, expose key flaws and propose solutions to inform the rules’ adoption by regulators, in a new book, Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance (Wiley, November 2010).

About Restoring Financial Stability

Previously, many of these faculty developed 18 independent policy papers offering market-focused solutions to the financial crisis, which were published in a book, Restoring Financial Stability: How to Repair a Failed System (Wiley, March 2009).

About the Authors