Fixing the Financial System

February 19, 2009

As policymakers and the public have been focused on the stimulus and the bank bailout, there remain tough policy questions about how to get at the root cause of the current economic problems – how to fix the financial system for the long-term. Director of the Initiative on Business and Public Policy Martin Baily discusses Fixing Finance: A Roadmap for Reform, laying out the long-term issues.


“We point to fact that having the people who create the mortgage securities have some stake in how they do again is going to provide a better private sector incentive. We also point to the credit rating agencies and we all know they fell down on the job that they were doing, they rated many of these securities as triple A even though the underlying risks were much greater. We think that’s a difficult one to deal with, we certainly think there should be some firewalls within credit rating agencies, so that the people that are giving the ratings are not the same people that are creating these securities, and there is a sharp line between the two, but in general we point to try an improve the incentive structure within the rating agencies.”

“…On the regulatory side, some of it is around the amount of information that’s disclosed. In general we say that if you get greater transparency no only will that help the markets to work better, but it will actually help the regulators to work better to make sure that they have in front of them the information that’s needed. Another point we make, and this echoes again some of the other reports that have come out in the group of thirty and so on is that it would be helpful to have a systemic regulator. What that means is that you may get a single bank go down, and that’s not the end of the world we’ve seen that happen over the years individual banks have gone down, but if that one bank going down brings down the rest of the system as seem to have happened to some extent when Lehman went down then that’s a problem for whole system, and we need an overarching regulator that knows what’s going on in the whole system, and how different banks are related to each other, so that if one bank has so called counterparty, in other words it guaranteeing some assets that belong to another bank in someway then we are aware of that, and we can take the necessary steps to make sure that the system itself does not become overloaded with that kind of risk.”

“…There is a danger of over-regulation, there are tremendous benefits that have been achieved through the financial sector, and through having the financial sector in the United States that is sophisticated and so innovative. Right now we see some of the costs of having that sector, and we are all paying the price of the instability that’s been created, but once you get through that once we get through that crisis we don’t want to go back to a situation where we don’t have derivatives, we don’t have securitized assets because those have allowed our economy to be what it is to some considerable degree.”