Vincent Reinhart Resident Scholar The American Enterprise Institute May 13, 2009 Jekyll Island, GA

1. Remarks on “International Exposure to U.S.-Centered Credit Market Turmoil”at the 2009 Financial Market Conference of the FRB Atlanta on “Financial Innovation & Crises” Vincent Reinhart Resident Scholar The American Enterprise Institute May 13, 2009 Jekyll Island, GA 1

2. Maps of my comments • Organizational issue • Costs of crises • Geometry of financial regulation • Cautionary note

3. Thanks to the organizers… • For the nonjudgmental “&” in the title • As opposed to “Financial Innovation and its Evil Spawn Crises” • Crises have almost always been with us • Unless considerable restrictions on financial flows are in place • Unlike debt or inflation crises, they are prevalent over time and across different regimes • This suggests a dynamic game between the public and private sectors Source: Reinhart and Rogoff (2009)

4. IS NOT the Initiating economic shock Magnification in financial markets Policy missteps Forbearance Clean-up IS When society writes the narrative to describe what just happened The narrative determines the legislative and regulatory response This has been done wrong before. In the 1930’s, we “learned” Fiscal policy is effective Monetary policy is not Competition can be excessive and Trade restrictions useful Costs include stifling innovation and making the system too complicated and vulnerable when we unlearn those lessons The most expensive stage of a financial crisis

5. Stijn Claessens is exactly right in focusing on the lessons learned from the crisis and their consequences for regulation

6. Gave individuality to geometric concepts Highlighted the difficulties of perspective and projection Consider the plight of a 2D entity visited by a 3 D object The most useful metaphor for the problem of international financial regulation was written in 1884

7. A national financial regulator… • Is a 2D entity observing a slice of a 3D large complex financial institution (LCFI) • Taken together, our global system is one in which many regulators observe different slices of the same entity • With the slices taken at oblique angles • The failure of oversight represents the failure of imagination • To visualize a complicated object properly

8. From this perspective, consider Claessens’ policy alternatives • Coordination through a “college of regulators” • Converged approach with common frameworks • International banking charter • World financial authority

9. Coordination through a “college of regulators” Converged approach with common frameworks International banking charter World financial authority Pool the visualizations Enforce a common shape at each cross section Invent a higher dimensioned authority Genesis worked because God started with a void A geometric explanation…

10. A cautionary note… • A LCFI arrives at its overall shape by manipulating its appearance in each national slice • Tax avoidance • Regulatory arbitrage • Too-big-to-fail protection • The resultant entity is • Quite complex in its full dimensionality • Hard to visualize at a lower dimension • Quite changeable from only a small rotation

11. Practical consequence of this complexity • From the outside, an LCFI • Hard to regulate • Leading authorities to be more likely to protect it • Hard for the market to monitor, lessening • Shareholder oversight of management • Counterparty discipline • Takeover threat • From the inside, an LCFI • Hard for management to supervise, creating • Incentive misalignments • Suitability problems • Compensation abuses • In a crisis, an LCFI • Less resilient and subject to sharp changes in view as objects turn and collide

12. Limit the number of standard charters by function Have holding companies hold Why? Easier to monitor entities in regional slices Aligns incentives better Easier to identify and protect systemically important parts, but not the whole More costly But so are all the alternatives And the most likely alternative, a utility-regulatory model—will be very costly indeed by stifling innovation Plea for the under-explored alternative—simplification (converged approach)