Mutual funds

Free Riding in Finance: A Primer

Many features of our financial system—institutions like banks and insurance companies, as well as the configuration of securities markets—are a consequence of legal conventions (the rules about property rights and taxes) and the costs associated with obtaining and verifying information. When we teach money and banking, three concepts are key to understanding the structure of finance: adverse selection, moral hazard, and free riding. The first two arise from asymmetric information, either before (adverse selection) or after (moral hazard) making a financial arrangement (see our earlier primers here and here).

This primer is about the third concept: free riding. Free riding is tied to the concept of a public good, so we start there. Then, we offer three examples where free riding plays a key role in the organization of finance: credit ratings; schemes like the Madoff scandal; and efforts to secure financial stability more broadly....

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An Open Letter to the Honorable Randal K. Quarles

Dear Mr. Quarles,

Congratulations on your nomination as the first Vice Chairman for Supervision on the Board of Governors of the Federal Reserve System. We are pleased that President Trump has chosen someone so qualified, and we are equally pleased that you are willing to serve.

Assuming everything goes according to plan, you will be assuming your position just as we mark the 10th anniversary of the start of the global financial crisis. As a direct consequence of numerous reforms, the U.S. financial system—both institutions and markets—is meaningfully stronger than it was in 2007. Among many other things, today banks finance a larger portion of their lending with equity, devote more of their portfolios to high-quality, liquid assets, and clear a large fraction of derivatives through central counterparties.

That said, in our view, the system is not yet strong enough. In your new role, it will be your job to continue to fortify the financial system to make it sufficiently resilient.

With that task in mind, we humbly propose some key agenda items for the first few years of your term in office. We divide our suggestions into five broad categories (admittedly with significant overlap): capital and communications, stress testing, too big to fail, resolution, and regulation by economic function....

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