Rajan on financial regulation

Chicago finance b-school prof Raghuram Rajan has a stimulating piece in this week's Bloomberg Business Week about how to make financial regulation more effective. Rajan focuses on tail risks, in particular events such as a crash in housing prices that have low odds (at least in the minds of most risk modelers three years ago) but severe outcomes. Banks are not afraid to take on these risks because current regs skew the game -- heads they win and tails we lose.

Rajan recommends that banks' capital requirements be increased, that way equity holders have more to lose if tail risk raises its ugly head again (which it will). He also wants to put debt holders on the hook by having some debt automatically convert to equity if the bank suffers significant losses. Also, other financial institutions would not be allowed to hold each other's debt to avoid contagion issues (remember that's why AIG got bailed out). The overall idea is to make debt holders more fearful that the government will not bail them out 100 percent next time. Maybe the debt would then be priced to reflect the true amount of tail risk.

In effect Rajan trusts debt holders and equity markets to do a better job of managing risk than simply adding more federal regulators and regulations.