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New Rules for the Financial Industry

Five sectors in need of behavioral change

The Obama Administration has begun to formulate new regulations for the U.S. financial sector, which I address in my book, “Real Estate and the Financial Crisis”. This column explores key regulations that are needed to prevent a future financial crisis.

Many business leaders believe that added regulations would diminish the creativity of the financial sector, reducing the American economy's efficiency.

However, I urge business leaders to open their eyes to the adverse economic conditions that deregulation has helped create in the past eight years. In short, the behavior of financial institutions unhampered by stringent regulations caused the credit crunch and then the overall recession we are now experiencing.

So, here's the salient question: What specific new regulations will be most effective in improving the financial sector's future behavior? The answer can be found in mortgage lending, securitization, credit rating agencies, off-balance-sheet lending, financial derivatives, commercial banks and regulatory agencies. I will address the first five subjects here.

  • Mortgage lending — All mortgage originators should be required to register with a central state or federal organization and provide information about their experience, assets, and policies. Mortgage lending financed with money borrowed from banks should be included on the banks' balance sheets.

    Mortgage brokers should require all borrowers to provide down payments of at least 5% to 10%. Originators should be prohibited from making mortgages that require monthly payments of more than 28% to 31% of a borrower's income, and originators should verify that income themselves. They should clearly explain to all borrowers what their interest rates are initially and in the long run.

    Originators should also make no loan exceeding the market value of the home covered. They should receive their origination fees spread over the length of the loans and should set up escrow accounts for property taxes and insurance costs.

  • Securitization — All lenders who pool and securitize loans should be required to retain at least 10% to 20% of the value of each securitized pool on their own books to ensure the loans are sound. Originators should also provide transparent information to all investors concerning what types of loans are included in each pool involved, and refrain from mixing many different types of loans in a single securitized pool.

    Finally, originators should provide special servicers who assume management of delinquent loans with handsome fees for helping borrowers work out new repayment schemes to prevent defaults.

  • Financial Derivatives — These instruments should be treated like securities. All persons or firms who enter financial derivative transactions should be required to register the nature and size of those derivatives with a centralized derivative exchange run either by the nation in which they operate or by an international agency.

    The central exchange should be the legal counterparty in all derivative transactions. The exchange should also report overall statistics on derivative activities to regulatory agencies, but maintain privacy about individual transactions. Derivative originators should report the reserves held by each counterparty, but keep the information confidential.

  • Credit rating agencies — These watchdogs should only be paid by the buyers of rated securities — not the originators — through a fee added onto security prices. Rating agencies should demand that originators provide evidence of due diligence concerning the loans involved, and they should follow up their ratings with interviews of investors to discover whether their repayment experience validates the ratings.

  • Off-balance-sheet lending — Banks should be prohibited from this practice. Organizations that borrow money from banks or other investors and then lend that capital should be required to hold reserves themselves, or ensure that the banks from which they borrowed funds are holding reserves. All lenders should also collect both their fees and interest over the course of the loans they make, rather than at the outset.

I will discuss commercial banks and regulatory agencies in later columns.

Tony Downs is a senior fellow at the Brookings Institution. He can be reached at [email protected]

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