This is a free e-book from the London School of Economics. It includes several stand alone chapters. Each one of them is written by a different expert or professor. The main underlying topics include how to manage and prevent future financial crisis. And, what would be the best financial regulatory framework to do just that.

1. The Future of Finance.
London School of Economics
July 2010
http://futureoffinance.org.uk/
A few summarizing thoughts on this tome extracted by Gaetan “Guy” Lion.
1) Hyman Minsky's model is hot. His model that the credit cycle is exacerbating the
business cycle is at the essence of the macroeconomics and regulatory concerns that all
the authors have. In other words, when the going gets good we over-lend to booming
sectors because collateral values go up. This quickly turns into speculative schemes that
are not self-financing anymore. The whole edifice of cards crumbles as borrowers
default, collateral values decline, and financial institutions extending the credit fail.
During the crash creditors retreat for their own survival and credit dries out just when it is
most needed. Too much credit extension on the way up and not enough on the way
down, that's how the credit cycle exacerbates the business cycle.
2) Real estate is truly the special sector most prone to exacerbated credit cycles because it
is the most convenient and prevalent form of secured financing worldwide.
3) The body of financial reforms either passed or contemplated does not go far enough.
And, will most probably lead to other financial crisis as they won't be able to restrain the
volatility of the credit cycle. We need to develop policy metrics that track specifically
real estate financing along with responding policy measures that restrain such financing
when deemed excessive. We need to implement higher capital requirements in general
and especially when undertaking real estate lending. We need to reduce credit risk by
mandating by law much lower LTV ratios (80% or less).
4) The Central Banks need to develop a framework of financial stability policies in
addition to monetary policy. They have to track more precisely the overall debt level
(Debt/GDP, etc…) and come up with dynamic policy tools to lean against the wind of the
specific sectors where excessive credit formation is taking place. This is different from
just using an interest rate lever that affects the entire economy indiscriminately.
5) There are also many debates about "narrow banking" whereby any bank accepting
federally insured deposits should be very restricted to very safe lending and investment
activities. The U.S. financial reform goes timidly in that direction by limiting banks
engagement in proprietary trading, derivatives, and alternative investments (hedge funds,
private equity, etc...). But, the consensus is that the U.S. financial reform does not go far
enough. Yet, Europeans are lagging behind the U.S. in this regard.
Within this “narrow banking” debate some of the authors use the colorful metaphor of
splitting the “utility” from the “casino” or the plain vanilla retail banking and payment
system functions from the Wall Street domain. So, the utility would be very tightly
regulated just like any utility is. And, there would be a regulatory framework so the
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2. financial system grid would be a lot more resilient to the failure of any financial utility
just like the electricity grid is resilient to any area incurring a temporary black out.
6) Compensation of the financial sector needs to be restructured. As is, financial
executives' compensation resembles a very profitable Call Option. Financial executives
are motivated to undertake the maximum risk to reap the maximum gain leading to large
personal bonuses. That's because if their strategy fails such financial executives bear
very little financial consequences. The Call Option at worst has a value of near zero
when the institution fails. This is because gains are privatized. But, losses are socialized
(bail outs, etc...). The authors suggest this has to change. Some of them propose that
bonuses be placed in some equivalent of an escrow account for up to 10 years to give
time for the risk to materialize on the transactions that generated the bonuses. This would
curb the risk taking behavior on Wall Street. And, it may have prevented the Bear
Stearns, Lehman Brothers, and AIG failures.
7) The issue of "borders" is really challenging. This entails how to enforce and
implement international coordination between countries. One author suggests a WTO for
the financial sector. It also entails how to regulate the "shadow banking" sector that by
definition usually escapes regulations. If the border issue is not resolved, financial
institutions will continue to play regulatory arbitrage and register their activities where
the regulatory environment is most lenient. This historically leads to a regulatory race to
the bottom whereby the domestic financial sector complaints it can’t compete against the
more lightly regulated overseas competitors. And, the regulators eventually acquiesce to
such political pressure.
8) The moral hazard of tacit government backing is often debated. Moral hazard would
be prevented if all creditors besides insured depositors would experience the full brunt of
a financial institution’s defaulting on their debt. And, several authors think it should be
the case. But, others acknowledge that by doing so you would exacerbate the systemic
risk within a fragile financial system. The solution of a “living will” is mentioned
whereby specific regulatory measures would be taken to resolve a failing institution in an
orderly manner so as to minimize or avoid costs to the taxpayers (bail outs).
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