Today's financial system is dominated by markets with institutions connected by short-term financing, securitization, derivatives, and other means. Yet regulations have focused on depositories, leaving regulators unprepared for the 2008 crisis. We suggest two key principles for regulatory reform. First, some changes in the financial system came as institutions lowered the burden of regulations through “regulatory arbitrage.” Reform needs to avoid driving businesses “into the shadows,” where risks may accumulate and sow seeds of future crises. Second, reform ought to improve transparency to reduce uncertainty and inter-linkages between players. We evaluate some of Dodd-Frank Act in light of these principles.

During the 1980s, insolvency of individual thrifts and the thrift deposit insurer created severe incentive problems. Lacking cash to close insolvent thrifts, regulators induced nearly $10 billion of private capital to flow into the industry through mutual-to-stock conversions. We test a theory of how regulators encouraged capital-impaired mutual thrifts to convert by permitting them to pay dividends rather than rebuild capital. We estimate the costs of this policy and interpret the 1991 Federal Deposit Insurance Corporation Improvement Act as requiring regulators to impose restraints on depository institutions parallel to debt covenants that prevent capital distributions by nonfinancial firms experiencing distress.

ABSTRACT During the 1980s, insolvency of individual thrifts and the thrift deposit insurer created severe incentive problems. Lacking cash to close insolvent thrifts, regulators induced nearly $10 billion of private capital to flow into the industry through mutual‐to‐stock conversions. We test a theory of how regulators encouraged capital‐impaired mutual thrifts to convert by permitting them to pay dividends rather than rebuild capital. We estimate the costs of this policy and interpret the 1991 Federal Deposit Insurance Corporation Improvement Act as requiring regulators to impose restraints on depository institutions parallel to debt covenants that prevent capital distributions by nonfinancial firms experiencing distress.