Ricardo Caballero makes a distinction between the role of leverage and that of aggregate risk concentration in the meltdown of the financial industry.

The problem in the current crisis was not leverage per se, but the fact that banks had held on to AAA tranches of structured asset-backed securities which were more exposed to aggregate surprise shocks than their rating would, when misinterpreted, suggest.

Thus, when systemic confusion emerged, these complex financial instruments quickly soured, compromised the balance sheet of their leveraged holders, and triggered asset fire sales which ravaged balance sheets across financial institutions. The result was a vicious feedback loop between assets exposed to aggregate conditions and leveraged balance sheets.

The distinction emphasized in the previous paragraph may seem subtle, but it turns out to have a first order implication for economic policy design. The optimal policy response to this problem is not to increase capital requirements (or to deleverage), as the current fashion has it, but to remove the aggregate risk from systemically important leveraged financial institutions’ balance sheets [emphasis added]. This should be done through prepaid and often mandatory macro-insurance type arrangements, which can accommodate valid too-big or too-complex to fail concerns, but without crippling the financial industry with the burden of brute-force capital requirements.

Interesting, but I’m not sure this is the right approach to the problem.  Although Caballero’s reasoning makes sense, the fact remains that aggregate risk was wholly amplified by massive amounts of leverage.  Further, the financial industry has proven widely incompetent in recent years of accurately assessing said risk–perhaps because it’s impossible.  But come on, Morgan Stanley, even this is pushing it a bit.

I’m no fan of regulation, and so the question becomes:  is it necessary?  And if so, where do we place it?  Do we go ahead with enforcement of capital requirements, or do we further complicate matters with some sort of above-proposed “macro-insurance type arrangement?”

Maybe the answer is neither; instead, we need to dig deeper.  Predatory lending? It’s got to go, no doubt.  Mike over at Rortybomb offers a great post in support of the CFPA idea (check out page 55 of the official white paper).  The main conservative argument against a CFPA is the regulation angle and the reduction of freedom in consumer choice that may result.  Jim Manzi has a well-written post in which he expounds on this viewpoint; one passage I’d especially like to highlight:

Further and most importantly, I think there is a different and better approach. I don’t think our basic strategy should be to forbid contracts that are only suitable for actual grown-ups, but instead to provide safe havens for the less competent. This could, in theory, include things like requirements for a “simple card” alternative and so on. I’ve tried to describe such an overall approach to financial regulation as “walls, not brakes”. It would not eliminate the problem of some sympathetic people getting over their heads in credit card debt, but should reduce it, while not giving up on the dynamism enabled by freedom of contract.

I couldn’t agree more.  Here’s the thing:  although I do believe predatory sub-prime lending contributed to the housing crisis and deserves to be addressed, the underlying issue is cultural, and consequently, much more widespread.  The fact that the market for sub-prime mortgages over the last thirty years has seen explosive demand suggests that people are living beyond their means in a manner that has ultimately incurred great social costs.  Combating the leftist notion that everyone deserves to be a homeowner would have gone much further in curbing such a crisis than any sort of increased regulation over the banking industry.  This is especially important to keep in mind in the face of looming additions to the welfare state, as we enter a new age of entitlement economics in America; will we ever learn?  And more importantly, what is to be done?