For an economist, the goal of financial sector policy and regulation is: market efficiency. The normative benchmark is a market which is an unbiased and rapid processor of information, a market that is deep and liquid. For many a bureaucrat, the goal of policy and regulation degrades to "let's not have a crisis on my watch". A great deal of the follies of the real world flow from this difference.
One aspect of crisis is the failure of large finance companies. Bureaucrats working in finance regulators often have a horror of a big finance company defaulting. This makes all big finance companies "too big to fail", with it's own consequent moral hazard. But the safety net is not given out by the bureaucrat for free. The typical price that is demanded is great gobs of equity capital. The bureaucrat finds safety in seeing lots of zeros for the capital. It is mechanically assumed that an entity with Rs.100 crore of equity capital is safer than an entity with Rs.10 crore of capital.
This leads to two kinds of mistakes. One problem is in situations like securities brokerage or in asset management, where equity capital really doesn't do much, and the bureaucrat needlessly burdens the firm by demanding a lot of equity capital. This serves to merely introduce entry barriers, reduce competition, and place the burden of earning an equity rate of return for that capital upon the customers of the firms. Such a drift towards demanding more equity capital is supported by big finance companies, who are too happy to have less competition. The other kind of mistake is that of getting comfortable that firms with lots of capital are safe. The best example of these are banks.
In the context of the pension reforms, we get repeatedly asked: "What happens if a pension fund manager goes bust?". Remarkably enough, it's actually possible to handle this problem rather nicely. The customer assets are - anyway - never on the balance sheet of the fund manager. This is where agency fund management differs fundamentally from either banking or insurance, where customers are inextricably intertwined in the balance sheet of the firm. The pension fund manager is just a consultant, who is giving instructions for transactions using customer assets which are sitting with a custodian. If one pension fund manager goes bust, the regulator replaces him with another pension fund manager. Customer assets needn't be affected when bankruptcy hits a pension fund manager. This aspect underlines why substantial equity capital isn't required to be a pension fund manager.
In the context of risk management, safety comes from clever systems and procedures; not from equity capital. An incompetent bunch can mess up a big finance company with plenty of equity capital. Conversely, sound procedures and well thought out processes can correctly deliver sound outcomes even when there are very big positions and small equity capital. The futures clearing corporation is the best demonstration of how safety comes out of brainwork, not equity capital.
On this theme, Futures Industry magazine has a fascinating article on how the futures clearinghouse handled the recent disaster at Refco.
The disaster at Refco unfolded at a blinding pace. The story started on Monday morning (October 10) with a brief statement from the company. On Tuesday, the CEO was arrested. On Thursday, the shares of Refco had stopped trading and the company was forced to shut down one of it's unregulated units for want of liquidity. You don't get a crisis where the events move faster than this.
Refco was a big firm. In September 2005, it was the 4th biggest Futures Commission Merchant (FCM) measured by customer assets, which stood at $6.5 billion. Plenty of customers got spooked by seeing TV footage of the CEO being carried away in handcuffs. As the article says: According to CFTC data, the total amount of segregated funds held at Refco fell from $6.47 billion at the end of September to $2.53 billion at the end of October. In other words, somewhere in the neighborhood of $4 billion was transferred to other firms in the space of about 15 working days. In fact, I find it remarkable that all customer assets didn't leave.
The article tells the story in full detail, and I encourage you to read the intricate dance-of-death that comes about when such events arise. The bottom line is that the extremely sudden death of the 4th biggest FCM was handled perfectly by the system of futures exchanges + clearing corporations. That's what I call systemic stability. This comes about by building sound procedures and being smart; not by repressing innovation, or by requiring vast amounts of equity capital.