Today 11:33 AM Insurance For Shadow Banking, Suggests Harvard Law Prof
To prevent the next financial crisis, how about making the shadow banking sector pay for insurance?
That's the suggestion of Harvard Law School's Morgan Ricks, since that sector, which includes investment banks, hedge funds and money-market funds remains largely unregulated and is prone to causing liquidity or insolvency problems:
The so-called “shadow banking” system arose over recent decades and achieved full bloom just prior to the recent financial crisis. That system proved unstable. And the shadow banking system was the central focus of the government’s emergency policy response to the crisis. Drawing on existing theory, this article argues that maturity transformation - the financing of longer-term financial assets with short-term (money-market) liabilities - is inherently unstable, and that this instability generates externalities. Consequently, government intervention may be warranted on grounds of economic efficiency. The article examines the efficiency characteristics of three potential approaches to policy intervention, which may be used alone or in combination: (i) ex ante risk constraints; (ii) ex post liquidity support; and (iii) insurance for short-term creditors. It shows that, under plausible assumptions, an insurance regime (supplemented with ex ante risk constraints to counteract the effects of moral hazard) is efficiency-maximizing. The proposed insurance regime would (i) make short-term liability insurance available to financial firms whose assets fall beneath a specified risk (volatility) threshold; and (ii) disallow financial firms whose assets exceed that threshold (and firms that are eligible for, but decline to participate in, the insurance regime) from funding themselves in the money markets. The article proposes functional criteria for establishing the efficiency-maximizing risk threshold.