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Oliver Hart and Luigi Zingales
How to Improve the Financial-Reform Law « Back to Story

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This is silly. First, the criteria (20% Jr. LT debt & less than 50 basis points pricing on CDSs) does not define a firm as "not systematically important", it defines the firm as not immenantly threatening...maybe. If they cross the thresholds, then what? THEN they should be regulated? After the market has percieved them as a threat, THAT is when you want to start preparing for their demise? Second, um, where you born in 2009? Because I recall markets failing massively to price risk accurately in 2006, '07, '08... You are lost in a solopisistic fantasy world of utopic market efficiences...
Thank you for this enlightening post, Oliver and Luigi. The points you raise regarding the Dodd-Frank Wall Street Reform show true insight into a pressing issue of today. Here's an alternate perspective on Section 913 and Dodd-Frank Reform for your viewing. Enjoy!
Thank you for this enlightening post, Oliver and Luigi. The points you raise regarding the Dodd-Frank Wall Street Reform show true insight into a pressing issue of today. Here's an alternate perspective on Section 913 and Dodd-Frank Reform for your viewing. Enjoy!
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I like the approach, I'm suspicious of the particular proposal. It essentially assumes that cds get price right, which only happens if traders have perfect information. If we end up with a situation where a whole class of assets is revealed to be garbage, the price on cds jumps, and a whole bunch of institutions get labeled systemically important just days before the system collapses. An example of this sort of revelation, might be learning that aaa cdos are built on a model that underestimates sub prime default correlation at the tail. If we're going to have a strict criterion, I'd much prefer it be based on the interconnectedness constraint. Clearly, we're bad at determing what firms are likely to default until shortly before it happens. And the math to measure interconnectedness is already available, economists just need to learn some graph theory and apply it. December 01, 2010 at 3:24 AM
Took me time to read all the comments, but I really enjoyed the article. It proved to be Very helpful to me and I am sure to all the commenters here It’s always nice when you can not only be informed, but also entertained I’m sure you had fun writing this article.

Only professors, who know nothing about how markets actually work, could write this. Do you know how thinly traded and easily to manipulate single-firm CDS contracts are? Any medium sized fund or financial firm could at any time easily tip a company into systemically risky territory under this plan. Short the company's stock and cash bonds heavily and then devote a fraction of that money to blowing out the CDS spreads, and you have a guaranteed money maker.
I think we've already tried the system of allowing the market to estimate risk, the market said the risk was near zero until just a few weeks before the whole system almost collapsed.

Give a read to Nassim Taleb's paper "the fourth quadrant". We as humans are poor at estimating risk or some risks can't be estimated without blowing up the system every 5 years.

The law should be breaking up companies too big to fail, and winding back the financial regulatory clock to the mid 1990's.
"The answer is to delegate these tasks to the market."

The market did such a good job valuing mortgage backed securities that it led to a world wide financial meltdown.

I think you might have a little bit of trouble convincing anyone that your suggested modifications to this legislation are a good idea.
I agree with the other comments - there is good reason to believe the market may not provide sufficient warning systems in a wave of overexuberance as experienced prior to the recent global financial crisis.

The second point I believe is of concern is what happens to a firms stock once it is deemed 'systemically important'. My reaction is that significant increase in regulation that would be applied (particularly if this increase is unanticipated by the market) would cause a significant additional decline in the share price. This double shock (the first shock being what caused the firm to become 'systemically important') could potentially creative an even worse situation where the firm must default due to the unexpected added burden of regulation.

There is potential here and I strongly believe that clarification of regulation is a good thing. But as mentioned, there are caveats that apply.
The key question I have (and I don't know the answer off the top of my head) is how well this would have worked in the current crisis. Did the market (and CDS prices) provide sufficient warning of the riskiness of AIG/Lehman/etc.? Or did the market assume that these "systemically important" players were entirely sound---right up until they failed. If the latter, then I don't see how this proposal addresses the challenges that the financial regulation bill is trying to address.
I have to confess this bill came as a surprise to me. The first question is: Why is the bill written by Chris Dodd and Barney Frank who were the "keepers of the flame" and all the way to the crash kept insisting that FAnnie & Freddie were in really good shape and didn't need any more oversight? Isn't that like setting the fox to guard the henhouse?
This article goes into great detail as to HOW the FED could help if it had more power. Key issue is could. How long before we realize that the FED and the banks it "serves" ARE the problem. We are now going on four years of government intervention (including the FED). It has not achieved anything other than sustaining and bailing out the group that caused the problem. There is no "trickle down", no economic expansion, and certainly no penalties to those that have done financially to the World what Hitler did militarily.
Would the regulations proposed in this article have worked if they had been applied to AIG? When AIG was issuing its credit default swaps, it had a high credit rating and the mortgage-backed securities which its credit default swaps insured had much higher credit ratings than they should have had. Like any insurance company, AIG was presumably using historical data based on the credit ratings of the debts it was insuring, and the historical data indicated that AIG could make a good profit in the long run by insuring these debts. Hart and Zingales need to propose specific quantitative criteria and back test these criteria on AIG to demonstrate that their proposel for regulations are workable.