[...] Ironically, faith in draconian regulation is strongest at the bottom of the cycle, when there is little need for participants to be regulated. By contrast, the misconception that markets will take care of themselves is most widespread at the top of the cycle, at the point of most danger to the system. We need to acknowledge these differences and enact cycle-proof regulation. [...] To have a better chance of creating stability through the cycle—of being cycle-proof—new regulations should be comprehensive, contingent and cost-effective. Those that apply comprehensively to all leveraged financial firms are likely to discourage the drift from heavily regulated to lightly regulated institutions during the boom. This drift is a source of instability since the activities that heavily regulated banks hive off often return to haunt them in the bust, through unforeseen channels. Regulations should also be contingent so that they have most force when the private sector is most likely to do itself harm, but impose fewer restrictions at other times. This will make regulations more cost-effective and so less prone to arbitrage or dilution.
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