In last week’s article, I made the point that we should expect that TBTF firms (those "too big to fail") will remain a permanent part of our financial system. The only way to avoid having to rescue them with taxpayer funds when they get into trouble is to prevent them from getting into trouble. This requires a substantially improved regulatory system.
But most of the recent proposals designed to strengthen the regulatory system are reminiscent of the old adage concerning generals preparing to fight the last war. A core problem is that we don’t know where the next shock to financial stability will come from, and what financial instruments will be used to make the big bets that ultimately turn sour. The next time, the malefactors may very well be firms that are not on anybody’s radar screen today, using financial instruments that do not now exist.