Interview with Daron Acemoglu

As for focusing on the asset side of banking, I think a lot of the emphasis among economists on regulation has been on the leverage side, on the liability side, so if we reduce leverage, that’s going to resolve things. Obviously, excessive leverage is a very dangerous thing, but I think that by itself is only half of the problem in the sense that even with limited leverage, there are going to be major interconnections in the system. In fact, you can have a lot of interconnections without having any net leverage; I can just borrow from you and lend to somebody else. In such a situation, there might still be major cascades from the failure of a few financial institutions, but there wouldn’t be net leverage. Of course, there are different ways of defining leverage that would deal with gross versus net.

But when there is this interconnected structure (which I think was the reason people were concerned, very rightly, about the collapse of the financial system), you may also want to make sure that these core institutions—those whose failure would be very costly for the system—should be discouraged from holding, or not even allowed to hold, certain assets, especially as the nature of those assets is still uncertain and evolving.

Again, it’s all with hindsight, but the allocational costs of excluding most major financial institutions (and it’s not clear how you would treat investment banks here), such as Bank of America or Citibank, from holding CDOs [collateralized debt obligations] and CDO-squareds might be quite limited, because these financial instruments might still be available and held by hedge funds, so it’s not as if the necessary capital would be totally cut off.

But it would mean that if, in fact, those instruments turn out to be more risky and much more sensitive to a slowdown or reversal in U.S. house prices than foreseen, that this will bring down a lot of hedge funds, but it wouldn’t bring down the core financial institutions.

So those sorts of regulations, I think, ought to be considered. But the difficulty is that you don’t want to make those regulations extremely detailed. I think the problem with the Dodd-Frank Act is that the amount of good it contains seems to be dwarfed by the amount of additional minute details it contains. That fails to achieve the intent of the regulation. It also gives better regulation a bad name, because people who are opposed to regulation can easily point to the page after page after page of paperwork and procedural things that Dodd-Frank wants you to do.

And I am not convinced that the Dodd-Frank Act is going to prevent the next financial collapse if the financial system actually continues on its current trajectory. I don’t think anybody can claim that they know what’s going to happen in the next five years in the financial sector, but the financial sector has become more concentrated. It’s very profitable, it is still investing in highly risky assets and, in fact, it hasn’t really cleaned up its balance sheet to a great degree. The bonus culture, for example, was one of the elements that contributed to the crisis—not by any means the only one, or the most major one, but it was certainly an important factor. It has remained the same. And the Dodd-Frank Act doesn’t really do anything to deal with that. I don’t think the Volcker rule does anything to deal with that either.

via www.minneapolisfed.org