A Critique of Current Proposals to Reform Financial Regulation

The notion that in reforming the financial system we should concentrate our efforts on making sure that banks are not "too big to fail" is based on an illusion. What we are looking for is regulation that makes the financial system less sensitive to error in the estimate of risk, not more so. There are two ways to do this. The first is to observe that this error is strongly correlated to the boom-bust cycle; counter-cyclical capital requirements will be part of this approach. Another way is to limit the flow of risks to institutions with a structural capacity for holding that risk.