A redesign of our financial system, driven by weaknesses revealed
during the credit crisis, will be based largely on the goal of
financial stability. Most of us thought we had it, but we did not. The
financial sector intermediates wealth across the real sector. When the
financial sector freezes up, as it did this year, consumers and
producers do not get efficient levels of financing for their
activities. Even worse, they understand the notion of self-fulfilling
expectations: If I assume that others will cut back on consumption and
production, then I should as well. This is how financial instability
led us into a significant recession.

The philosophy of our market-based economic system has been that
individual actors, by looking out for themselves, should be regulated
mainly in order to mitigate “negative externalities” such as pollution.
If I do not bear much of the costs of my air pollution, for instance,
then my polluting activities should be regulated. The same applies to
systemic risk in financial markets, another form of pollution. Systemic
risk is the threat that financial institutions will fail
catastrophically or become so crippled by a loss of capital that
consumers and producers have difficulty getting financing for their
activities. Governments attempt to reduce systemic risk by regulating
the levels of capital that banks maintain. Those capital standards, or
at least their enforcement, failed to prevent dramatic losses in the
housing market from being trapped inside banks, causing this credit
crisis. Something went wrong and needs to be fixed.

Several things went wrong. A large amount of wealth created by the
“great moderation,” a relatively stable and healthy economy over many
years, found a seemingly convenient investment: securities called
collateralized debt obligations (CDOs) that offered repackaged
home-mortgage payments. Because there was a general and misplaced trust
that home prices would not fall broadly, highly rated CDOs were
believed to be quite safe, and also promised somewhat higher payments
than, say, Treasury bonds. Investors flocked to CDOs, creating demand
for more, encouraging additional home ownership, and further driving up
home prices. Once home prices began to fall, however, this
self-reinforcement went into reverse, and CDO investors lost plenty.
Many large “sophisticated” financial institutions held vast quantities
of mortgage-related securities and were not sufficiently capitalized to
withstand the losses. The most leveraged, Bear Stearns, Lehman, AIG,
and Merrill Lynch, went first. Some went out of business; some had to
be rescued. Even relatively tightly regulated institutions, such as
IndyMac, Washington Mutual, and Wachovia, went south. The federal
mortgage agencies, Fannie Mae and Freddie Mac, were special cases, but
their failures were also caused by insufficient capital. The financial
crisis went global and morphed into a costly global recession.

Financial institutions were extremely unlucky, or took more risk
than was healthy for the economy. Going forward, they should presumably
take less risk. Regulators, currently focused on treating the wounded,
will soon turn to the task of redesigning our regulatory framework. The
era of large and lightly regulated investment banks is over. The only
two left standing, Morgan Stanley and Goldman Sachs, have become
chartered banks, now overseen by the Fed and other regulators. Bank
capital standards, which had only just been overhauled under the Basel
II international accord, will be reviewed for weak links. Revisions may
include higher capital requirements for off-balance-sheet exposures,
such as structured investment vehicles (SIVs), and for extremely large
concentrated investments, whether triple-A rated or not.

The credit derivatives market covered large default losses from
failing home mortgages and financial institutions. Despite dire
predictions, it appears that settlement claims in this default
insurance market have been processed relatively smoothly. Regulators
are right to insist, though, on central clearing of credit derivatives,
a process by which bilateral exposures between counterparties to a
derivatives contract are converted into bilateral exposures between
each of the original counterparties and a central clearing
counterparty. Clearing allows positive and negative exposures to be
more easily and safely offset, and reduces the potential for domino
effects, by which the failure of one financial institution could cause
the failure of another. Regulators should also have more systematic
information on counterparty exposures, whether from credit derivatives
or other forms of risk taking. (For more on the importance of clearing
and disclosure, see my op-ed in the Wall Street Journal, Oct. 29, 2008, and my Senate testimony of July 14, 2008.)

Although weak internal management of some financial institutions
appears to have played a significant role in the credit crisis, it is
difficult (if not counterproductive) to regulate good management. For
instance, an attempt to prescribe by regulation the types of
derivatives that financial institutions may trade could stifle
innovation and efficiency, and could in any case lead to a migration of
trading elsewhere. I do believe, though, that a renewed focus on the
regulation of systemic financial risk is inevitable and timely.