In traditional Chinese medicine, the doctor is paid as long as the patient is healthy. The patient comes in four times a year for a checkup, with adjusted lifestyle recommendations. Payment is stopped once the patient is ill. In the US, as long as the economy is healthy, “the financial doctor” in the form of the prudential regulator is considered redundant. Moreover, the prudential regulator is frequently viewed as a spoiler who inhibits growth and development. This is the paradox of prudential regulations in a capitalist economy—the better the regulator’s performance, the lower the demand for its services. The success of the regulator or a prolonged period of economic tranquility leads to complacency, reducing the demand for his services, inducing under-regulation, which leads to a financial calamity. While the identity of economic actors that benefited directly from crisis avoidance is unknown, the cost and the cumbrance of regulations are transparent. Hence, crises that have been avoided are imperceptible and are underrepresented in the political discourse, and the demand for regulation declines during prolonged good times, thereby increasing the ultimate cost of eventual crises.

The 1990s was a prolonged period of what was perceived as the ‘great moderation’ of the global economy, a period of remarkable decline in the variability of both output and inflation, reducing the demand for financial regulations. This may explain the growing acceptance during the 1990s-2000s of Greenspan’s seductive “market-stabilizing private regulatory forces” doctrine. Deepening global financial integration, and the growing confidence that global risk diversification, reduced systemic risk sharply lowered the risk premium. The successful private bailout of Long-Term Capital Management (LTCM) in 1998 was taken as a vindication of the efficacy of “market-stabilizing private regulatory forces,” where the main role of the Fed is providing coordination services among the private parties involved in the bailout. However, the resultant complacency provided the background for the onset of the present crisis—calamity akin to a global LTCM on steroids. This time, however, the crisis is too big to be dealt with by private bailouts. The present challenge of rethinking the global financial architecture is to upgrade regulations in ways that recognize the paradox of prudential regulations during times of deepening financial integration, while taking into account the emergence of new domestic and foreign players, and new exotic financial instruments.

While the seeds of the present crisis were mostly homegrown, international flows of capital magnified its costs. Although it is a mistake to single out any class of foreign players as the key domino, the crisis awakened us to the need to overhaul global financial regulations. Global financial integration produces the by-product of “regulatory arbitrage”: capital tends to flow to under-regulated countries, frequently resulting in excessive risk taking, in anticipation of future bailouts. Dealing with “regulatory arbitrage” requires coordinated prudential regulations that should apply as equally as possible to domestic and foreign players. Such regulations should be tailored to the risk category and exposure of each player above a minimum size, independent of the player’s nationality. This would require a major overhaul of the information gathered by regulators and provide the benefit of setting a minimum global standard on information disclosure, as well as margin and leverage requirements on all financial players above a minimum size.

A coordinated globalized prudential regulation, by increasing the cost of prudential deregulation, would mitigate the temptation to under-regulate during prolonged good times, thus adding a side benefit. Thereby, it would act like Odysseus’ solution to the temptations of the Sirens: sealing sailors’ ears with wax. We review in greater detail the need for comprehensive prudential regulation, and discuss possible implications on the investment practices of sovereign wealth funds (SWFs)—savings funds controlled by sovereign governments that hold and manage foreign assets—and international hedge funds.

The Need to Regulate

Financial crises are as old as financial intermediation, and there is no reason to expect them to disappear. Financial intermediation entails maturity transformation—funding a longer-term tangible investment with shorter-term savings. The essence of a financial crisis is a rapid financial disintermediation due to financial panic. In practice, this involves a “flight to quality,” where savers attempt to liquidate assets in financial institutions due to a sudden increase in their perceived risk, moving their savings to safer assets, such as foreign currency and foreign governments’ bonds in developing countries, or currency, gold, and government bonds in the OECD countries. As such, financial intermediation is exposed to financial fragility, in which heightened perceived risk may lead to liquidation, putting the entire financial system at risk. The ultimate manifestation of financial crises includes bank failures, stock market crashes, and currency crises, occasionally leading to deep recessions. The economist Hyman Minsky theorized that financial fragility—which is related to the business cycle and to leverage—is a typical feature of any capitalist economy. These considerations are at the heart of the large literature propagated by the stock market crash of 1929 and the Great Depression, including FED Chairman Ben Bernanke’s seminal works on these topics.

Economic reasoning implies that the cost of inappropriate prudential regulation is magnifying the hazard of pre-existing distortions. A vivid example of such a distortion is moral hazard: this arises when investors believe they will be bailed out of their bad investments by the taxpayer, and therefore have little incentive to undertake proper monitoring of their investments (Heads I win, tails the taxpayer loses.). In these circumstances, taxpayers subsidize the investment. A frequent rationale for such bailing out is the “too big to fail” doctrine—the cost of systemic risk triggered by the failure of large financial institutions frequently implies that, independent of the ideology of the financial regime, when push comes to shove, tax payers will bail out large financial institutions. The lesson of the Great Depression is that failure to do so is too costly. Minimizing the costs of such bailouts necessitates prudent regulations. The challenge for the regulator is that, due to the nature of market forces and the interaction among market participants, it is impossible to predict the timing of a crisis. But the ugly head of moral hazard is widespread. For example, purchasing a house with zero down payment entails private profits when the house appreciates, but social losses when the house depreciates significantly, when the “owner” may walk away from the mortgage, saddling taxpayers and the community with the losses. Similarly, when a bank financing mortgages sells its portfolio to a third party, the bank’s profit base switches from the provision of prudential services associated with issuing mortgages into a commission-based service, thus reducing the bank’s incentives to properly monitor the allocation of credit. Both distortions can be mitigated by proper regulation, including imposing a significant minimum down payment on the homeowner, and capping the share of mortgages that the financing bank can package and resell in the market place. Enforcing these regulations calls for the watchdog to be the party spoiler, described by William McChesney, FED Chairman during the 1950s-1960, as “tak[ing] away the punch bowl just as the party got going.” This activity has been in short supply in recent decades.