On April 15, Raghuram G. Rajan, the Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago's Booth School of Business, presented "The Credit Crisis and Cycle Proof Regulation," the Homer Jones Lecture at the Federal Reserve Bank of St. Louis.
Rajan said there is broad consensus on the causes of the current financial crisis:
(1) The U.S. financial sector misallocated resources to real estate, financed by exotic new financial instruments.
(2) A significant portion of these instruments found their way, directly or indirectly, into the balance sheets of commercial and investment banks.
(3) These investments, in turn, were largely financed with short-term debt.
(4) This potent, volatile mix imploded in 2007.
Although he emphasized that there's "plenty of suspects and enough blame to spread," Rajan offered what he called "cycle proof regulation" to help head off a future crisis. Among other things, he proposed:
Highly leveraged financial institutions would be required to buy fully collateralized insurance. This insurance would inject contingent capital into those institutions when they're in trouble.
Financial institutions considered "too big to fail" could be asked to develop a bankruptcy contingency plan that would lay out how they would resolve themselves quickly. He said such a "shelf bankruptcy" plan would require banks to track and document their exposures much more carefully and in a timely manner.
"A crisis offers a rare window of opportunity to implement reforms," Rajan said. "The temptation will be to over-regulate, as we have done in the past."