Yesterday was a busy day in D. C. for financial reform. FDIC Chair Sheila Bair gave an interesting speech, in which she called for a requirement that financial institutions maintain a reserve fund to be used to assist in their unwinding in the untimely event of their financial demise. Bair's proposal that firm's self-insure for their own funeral contrasts with Senator Dodd's proposal that the collection plate to cover the burial be passed out to the remaining members of the Wall Street congregation.

Bair's proposal might create a dilemma for regulators when faced with an ill patient: should regulators allow the struggling institution to tap into its reserve fund to try to save itself or should the money be reserved only for dismantling the firm?

There is another question that has been troubling me. Whatever happened to the idea of charging appropriate risk-based premia for deposit insurance?

Bair also spoke on capital requirements, which ought to top the list of reform priorities. There are a lot of causal explanations for the crisis and many potential fixes, but addressing capital requirements is essential. I've written about how the failure of capital requirements contributed to the crisis, including through the SEC's failed Consolidated Supervised Entity experiment.

I'm now convinced that capital requirements are even more important to reform --- not just for weathering a financial crisis, but also for preventing one. Capital requirements ensure that financial institutions maintain some cushion to ride out the storm of an economic downturn or higher-than-expected losses. But capital requirements also help prevent the storm from getting really bad in the first place.  By requiring that institutions hold money in reserve, these rules restrict the amount of loans or investments that firms can make. If capital requirements are lowered, firms can invest and lend more and asset prices can surge. Lower capital requirements essentially increases the money supply and can contribute to inflation in a given asset market. So lowering capital requirements may produce the double whammy of overheating a market and leaving financial institutions more vulnerable should the market melt down.

Bair's comments on reforming capital requirements would be striking (had they come from any other regulator):

"There is little doubt that there will be eye-popping reductions in required capital when the good times return to banking."

This comment points to two elements essential to financial reform in general. The first is designing financial regulations that are countercyclical not pro-cyclical. The second is devising regulations that can withstand the enormous political pressure to loosen standards and provide more punch to a party that is starting to get out of control.

This is perhaps the hardest question in financial reform; not what new substantive regulations we need or which agency should get responsibility for which piece of turf, but how do we make sure regulators use the powers they already have.

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