Monoline Regulations to Control the Systemic Risk Created by Investment Banks and GSEs

The paper offers a framework and a specific proposal for the re-regulation of key components of the U.S. financial system in the aftermath of the subprime mortgage crisis. It begins with a review of those aspects of the subprime crisis that required the large, observed government interventions, namely the feared bankruptcy of individual banks, insurers, and government sponsored enterprises with the potential to create a meltdown of the entire financial system. The paper then develops legislative responses that would make future systemic failures and bailouts of this magnitude highly unlikely. The paper's key analytic device is to distinguish two financial firm activities: (1) risky investment activities ("hedge fund" division) capable of causing firm bankruptcy, and (2) market-making and related activities ("infrastructure" division), the failure of which would have systemic implications. The goal of the proposed regulatory change is to ensure that the infrastructure division is bankruptcy remote and can operate on a stand-alone basis if necessary even when losses from the hedge fund division threaten the holding company's solvency.