Supervision and regulations

Supervision and regulations 

Can audit and enforce capital and liquidity requirements.

Can require that financial institutions issue some contingent convertible debt that will become equity should equity capital become impaired.

Can put limits or prohibition on certain types of concentrated bank lending.

Can require "living wills" in which financial intermediaries indicate, on a ongoing basis, how they can be liquidated expeditiously with minimum effect on counterparties and market.

The relative stability of average net income-to-equity ratio dating back to the post-Civil war years reflects an underlying competitive market-determined rate of returns on intermediation, a result consistent with stable time preference and real long term interest rate.

"Too big to fail ", or more appropriately "too interconnected to be liquidated quickly "

Sovereign credit creates institutions that are too big to fail, a short step from crony capitalism. More important, it becomes addictive, offering a seemingly politically cost-free avenue to a solution for every conceivable adverse abbreviation in economic activity.

The crisis has demonstrated that neither bank regulators nor anyone else can consistently and accurately forecast whether subprime mortgage will turn to toxic or to what degree, or a particular tranche of a collateralized debt obligations will default. Regulators can sometimes identify heightened probability of underpriced risk and the existence of the bubble, but they almost certainly cannot effectively time the onset of crisis.

Many analysts argued that forecasting is not required for regulation. But cycles are not uniform, and it is difficult to judge at any point in time exactly where we are in the cycle.

Bank regulators are perforce being pressed to depend increasingly on greater and more sophisticated private market discipline, the still most effective form of regulation. Indeed, these developments reinforce the truth of a key lesson from our banking history- that private counterparty supervision remains the first line of regulatory defense.

A bank examiner cannot make a judgment and neither can a credit-rating agency.