Many proposals add ever-more elaborate regulations to an already baroque regulatory system – one that is already unmanageable. We propose instead to make things much simpler.
ERNs [Equity Resource Notes] are a counterweight against pro-cyclicality. They make capital raising – and therefore lending – easier rather than harder in recessions. Counter-cyclicality also increases the credibility of the plan, because there will be no incentive to scrap it in bad times. Jettisoning complex capital rules, and simply transferring tail risk back where it belongs (with private investors) takes taxpayers off the hook and ensures that banks with profitable opportunities can use them.
In short, our system eliminates distortionary incentives for regulatory arbitrage and forbearance, facilitates counter-cyclical raising of unsecured capital, and clearly and credibly assigns losses to private investors where they belong.
While we rely on markets to determine banks’ risk capital requirements, our system is robust to the market being wrong, or less accurate on average than regulators’ or banks’ internal models. By contrast, current regulatory models will often lose money, and perhaps cause a crisis, if markets are right.The simplest ideas are often the best.