Last December I wrote a post, "Good Question: What Good is Wall Street". The post generated quite a lot of discussion but not in the comments. The theme of the post was:
"Banks went astray when they diverted so much capital to support trading schemes in the new derivatives....., which was not part of their original mandate as utilities."
Much discussion circulated around the use of the word "utility" and their "mandate to distribute capital".
Now it is one year later, December 2014. What has Washington learned? Maybe the better question is how should Washington be thinking about banking regulation or perhaps how do we better regulate derivatives. This quote from political economist William Tabb is insightful.
“Technological revolutions and political upheavals condition economic possibilities, which then become the givens for sustained periods of seeming stability in which regulatory regimes designed for the conditions of the social structure of accumulation of the era lend a semblance of orderly progress. These institutional forms, appropriate to one stage of development, become a drag on the development of new forces and emergent relations of production. The vitality of market forces create in their wake social problems which, when they become severe enough need to be addressed through spirited struggle out of which new rules, regulations, and institutions form. [My bold emphasis]
A bit of a leap, but I think the crisis of 2008 shows us that in finance we can no longer regulate institutions and must instead regulate financial instruments such as derivatives. Regulation of banks proved inadequate in part because so many of the key market participants were not banks or regulated by the federal government. Now if we no longer regulate banks as the means to control the financial system, why cannot anybody offer deposits, loans, insurance etc. Put $100 million on deposit with a depository, pass a background check and you can be a "bank", an "insurance" company or a mortgage lender. We could use the Bitcoin infrastructure to record transactions, document margin deposits, etc. Loan to equity ratios, derivatives outstanding to equity ratios, return on equity calculations and similar financial reports would serve as the control mechanism. Such an approach to regulation, based on assets, equity capital and profitability would provide the regulatory control, except Bitcoin would be calculating daily ratios and temporarily shutting down businesses that exceeded their permitted ratios. All transactions would be required to be done on Bitcoin or a similar system exclusively. Regulations would have to be simple enough that computers could calculate ratios, a big improvement over the current system. Asset quality would not be regulated but rather would be "managed" by the market.
The big debate would become how much capital does one have to reserve for a particular financial instrument. Maybe we just say, if it is not a debt or equity instrument, then it is a derivative/insurance product and use three reserve requirements. For example when you strip a mortgage, the principal would be classed as a debt but the interest stream would not be a loan and therefore subject to derivative/insurance reserve requirements.
This scenario might appear fanciful. As soon as the market players start trading outside the system of government regulation my scenario looks more attractive. IT technology is transforming how financial markets work and it is time to take a completely new look at regulation.
Note: The Tabb quotation is from Complexity and the Economy by Brian Arthur. Excellent book.