Aurora Borealis
1 June 2014 CFA Institute Journal Review

Leviathan of Last Resort (Digest Summary)

  1. Michal Szudejko

Governments should completely change the way they approach financial market regulations. Public involvement can introduce imbalance in the risk positions of market participants, which results in excessive risk taking. One remedy would be to reduce state support in favor of market self-regulation and transfer the cost of risk taking from taxpayers onto actual investors.

What’s Inside?

The author contributes to the discussion on establishing a Federal Risk Insurance Corporation (FRIC). This insurance would essentially allow investors in mortgage-backed securities (MBS) to make far riskier investment decisions than they normally would. The author argues that this corporation and similar examples of government involvement contribute to the overall instability of financial markets and ought to be replaced with strict solutions that do not involve public funds or guarantees in case something goes wrong.

How Is This Article Useful to Practitioners?

The author comments on the plan to replace Fannie Mae and Freddie Mac with the FRIC. In essence, this movement would collateralize 90% of the risk taken by MBS investors. But in the author’s opinion, it is not a lack of regulation that catalyzed the most recent disruptions in the mortgage industry, but rather, the imbalance in the risk levels as a result of excessive governmental presence.

Offering examples of government regulation in the financial industry, the author notes that even though the regulation is aimed at protecting individual investors, it increases the chances of unbounded risk taking. These examples include the excessive amounts of deposits secured by the government, corporate lending rates with insufficient risk components, and subsidies to banks that are much higher than their actual profits.

Minimizing governmental involvement and taking actions aimed at increasing balance among financial instruments that are available to investors can encourage market self-regulation and a more careful approach toward risk. These changes are essential for financial markets to play their role in the contemporary economy. One major obstacle in this process may be the significant level of globalization in the banking industry.

The article may be of interest to all mortgage industry participants, from regulators to bankers to individual investors. As far as the academics are concerned, the ideas presented in the article may lay an excellent foundation for further, more scientific verification of the issue.

Abstractor’s Viewpoint

The article is an interesting piece of writing. It represents a voice in a discussion that should involve both market practitioners and academics. As the financial turmoil in the previous decade has shown, regulations in the financial markets might have significant effects many years after they have been enforced. The learning point is that whenever new ideas in this area emerge, an analysis from multiple points of view is needed.

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