How to create better financial regulation

From the comments of Saturday's blog post:

The trick is to have professional regulators who actually believe in the rule of law. Bush's fox-watching-the-henhouse approach was destined for failure.

My response:

Lots of people like to blame stuff like this on the opposing political party. For example, note how Republicans like to blame the housing bubble on the Community Reinvestment Act.

The truth is that nobody of any political affiliation likes to step in and take away the punchbowl when everyone's partying. Just look at the failure of anyone to do anything about the stock market bubble during Bill Clinton's second term.

Bubbles are caused by human nature. Since regulators are human beings, they are as susceptible as anyone else. How many home-owning regulators of any political affiliation would have wanted to rein in the rapid rise in housing prices, for example?

Instead what are needed are mathematical rules, such as requiring home buyers to make 20% down payments when buying homes. (Note that under President Obama and a Democratically-controlled Congress, the FHA is actively encouraging absurdly low 3.5% down payments.)

Larger down payments would encourage home buyers to care less about monthly payments and more about overall price. They also would give home owners a bigger buffer to protect themselves when home prices fall. They would also force home buyers to have more skin in the game, so they will be less inclined to just walk away when their home price falls.

All financial institutions should be required to maintain sufficient capital reserves, not just traditional banks. The required reserve ratio should automatically rise during booms and fall during busts. Countercyclical reserve policy like this would help stabilize both the financial system and the money supply.

Finally, teaser rates should be outlawed. Teaser rates are intended to take advantage of people's innate susceptibility to hyperbolic discounting. If someone isn't willing to buy a home based on the regular interest rate and the regular monthly payments, then they shouldn't be buying the home.