H. Nejat Seyhun, the Jerome B. & Eilene M. York Professor of Business Administration and professor of finance. Ross School of Business, University of Michigan. With his permission we publish this article that is also at http://bit.ly/dBdyda U of M News and Media
In the year and a half since Lehman Brothers failed, we have heard a chorus of urgent calls for new regulations to prevent a repeat of the financial meltdown of 2008. Despite many proposals, however, no new regulations have gained traction toward enactment into law.
These proposed reforms have included requiring additional fees for banks, restricting the size and scope of banks, separating banks’ depository functions and trading activities, and stripping the Federal Reserve of its authority over banks and creating new regulatory institutions to oversee them. Yet, the Fed complains that it needs additional policy tools to manage the economy.
There is a simple, time-tested solution that would prevent a repeat of the recent financial crisis — a margin requirement for over-the-counter transactions (private transactions between banks or other parties).
In the aftermath of the 1929 stock market crash, the margin requirement for stock ownership (the amount that an investor must deposit in a margin account before buying on margin or selling short) was raised from 10 percent to 50 percent. This simple requirement has served us well for the past 80 years and has controlled excessive risk-taking in the stock market by individuals. Unfortunately, the margin requirement applies only to the stock market and exchange-traded products. There have been no margin requirements for over-the-counter transactions, where the bulk of trading takes place.
I propose that we immediately implement a margin requirement for all financial transactions, including over-the-counter transactions. The initial margin would be set small, even as low as one or two percent, and adjusted over time as needed, similar to exchange-based transactions. In addition to initial margins, maintenance margins would be required to take into account gains and losses on a day-to-day basis. To facilitate posting of the margins, a clearinghouse would be required to act as a counterparty to all transactions. In the United States, the Federal Reserve is well suited for this purpose. If it chooses, the Fed can pay interest on the margins, thus acquiring an additional policy tool.
Will margin requirements for over-the-counter transactions prevent a repeat of the financial meltdown of 2008? The answer is surely yes.
- Margin requirements would apply to all firms, financial as well as nonfinancial.
- Margin requirements would be flexible and subject to change by the Federal Reserve. If systemic risks increased, the Fed can simply increase the margin requirements, thereby stepping on the brakes and requiring de-leveraging. If the economy cools or goes into a recession, the Fed can reduce the margin requirement or temporarily set it close to zero, thereby encouraging greater risk-taking.
- Margins would automatically control both the size and risk of all institutions and eliminate moral hazard problems. Firms experiencing losses would have to post bigger margins to cover their losses. To do so, they might need to liquidate their risky money-losing positions before they become too large, thus automatically reducing their size and risk levels.
- Margin requirements would provide continuous updated information flow to the Federal Reserve, allowing it to monitor all financial institutions.
We already have a margin requirement in the stock market — the initial margin is 50 percent while the maintenance margin is 25 percent. We have margin requirements for all exchange-traded products. We have an informal margin requirement in the housing market, although this has not always been observed and should be made into a regulatory mandate as well. A simple way to achieve this objective is to require that all home buyers put down 20-25 percent of the purchase price as a down payment. Having a required margin in the housing market would prevent both housing bubbles as well as control the system-wide risk levels.
A saying goes that necessity is the mother of all invention. One benefit of the crises of the past is that they taught us expensive lessons on how to control risk. Let’s use our hard-earned knowledge and implement a margin requirement for all financial transactions.
H. Nejat Seyhun is Professor of Finance and Jerome B. and Eilene M. York Professor of Business Administration at the Ross School of Business, University of Michigan, where he has twice served as the chairman of the finance department. He holds a Ph.D. in finance (1984) from University of Rochester, Rochester NY. Professor Seyhun’s research has been quoted frequently in the financial press including the Wall Street Journal, New York Times, Washington Post, Newsweek, Business Week, Bloomberg Business News, and Los Angeles Times. Among his past consulting clients are Citigroup, Towneley Capital, Tweedy, Browne, and Vanguard.