Placing size limits on financial institutions is not the best solution in addressing systemic risk, an expert told the Bank Structure Conference hosted by the Federal Reserve Bank of Chicago Thursday.

University of Chicago Professor Raghuram Rajan suggested having banks reserve capital even in good times is akin to keeping buckets of water at the ready in case there is a fire.

When the fire doesn't come, the water, or capital, is used for other needs - drinking, washing, etc. However, if and when a fire does come the reduced buckets are not enough to put it out.

Rather than approaching capital like buckets of water, he suggested contingent capital requirements, which he likens to a sprinkler system.

The idea is that bank debt would be converted to equity, and to require that bank capital wouldn't go below a certain level. The sprinkler system would allow banks an incentive to raise equity in time to fight the fire, or financial crisis.

Rajan rejected the notion that lawmakers and regulators should significantly limit the activities of some institutions in order to prevent them from becoming systemically important, noting that could have enormous costs in the longer run.

It is obvious that some institutions get large enough to cause systemic risk, Rajan said. He noted that the size of an institution itself is hard to define. Does it include assets? Profits? Transactions? Lawmakers would have to examine this.

In addition, he warned against banning certain activities, noting that trying to regulate through banning practices could spark a bad reaction from the private sector.

We have to be careful of banning this and banning that, Rajan cautioned. The private sector will react.

Overall, Rajan said that it is essential to examine regulation from top to bottom as the nation moves out of the crisis.

I think if we merely require more of the same we will be condemned to repeat the mistakes of the past, he warned.

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