Friday, June 19, 2009

Fail safe regulation!

Obama's financial sector regulation is under scrutiny. In one word will it prevent crisis - no. Will if prevent this crisis from occurring again - possibly. Why? Is it so ineffective? Well no, the terms are well intentioned. What we need is Fail-Safe regulation.

Fail Safe - engineering definition v/s common definition
There are two definitions of fail safe. Generally, fail safe means does not fail. Whereas in engineering fail safe means - when it fails it does not cause harm. It is impossible that regulation will never fail. So financial regulation needs to apply engineering definition.

Using Engineering fail safe regulation...
Now we need not regulate hedge funds, or investment banks or increase their capital adequacy beyond certain limit. We simply need to ensure that when banks fail they do not take the world with them. Hence I proposed the new banking system.

In the new structure, we should see polarization of financial institutions along the risk axis. The high risk FIs, like hedge funds and private equity, will never be bailed out. Investors into these asset classes should sign a government disclosure that they know they can potentially loose their money - just like hedge fund investors. We will see more groups joining hedge funds and private equity in this pole.

In any case regulation has to take responsibility for low-risk financial infrastructure part of the system, leaving other pole to dynamics of capitalism.

In Sum...
The current regulations are good intentions with potentially poor outcome. I hope Obama advisors are able to get around to the engineering fail-safe regulations.