Economic recovery

The ongoing financial crisis has made it obvious that we need to overhaul financial regulation. The fundamental problem is by now well known. Financial institutions — banks, insurance companies, hedge funds, and others — have incentives to take excessive risk. Devising effective regulation to control such behavior will not be easy because the incentives to take excessive risk derive from many sources, the measurement of risk is difficult, and regulations intended to control risk can hamper useful financial innovation.

Nevertheless, there is remarkable consensus among finance experts on the broad outline of regulatory reform including the following:

Systemically significant financial institutions — those that expose the financial system to greater risk — should be subject to tougher regulation.

More sophisticated measurement of systemic risk must be collected from a wide variety of financial institutions, not just banks.

One regulatory authority should be in charge of measuring and controlling systemic risk.

When there are failures of systemically significant institutions, regulators need enhanced authority to deal with them.

The initial steps taken by the Obama administration are encouraging. Treasury has announced its support for regulatory reform along these lines and has already proposed legislation to enhance regulatory authority over failing institutions. However, comprehensive regulatory reform will take time, particularly if there is to be international coordination, as there should be.

As the financial crisis abates and the economy recovers, it will be tempting to shift focus to other important matters. But the Obama administration should continue to pursue reform of financial regulation to promote economic growth and financial stability despite likely challenges from financial institutions to limit the scope of reform.