Young Economics.

How shall we regulate global finance?

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The Economist is hosting an online roundtable discussion based on a short article by Dani Rodrik, one of my favourite thinkers.  The subject of discussion is global financial regulation.  Rodrik writes:

[T]he logic of global financial regulation is flawed. The world economy will be far more stable and prosperous with a thin veneer of international co-operation superimposed on strong national regulations than with attempts to construct a bold global regulatory and supervisory framework.
. . .
[E]ven if the leading nations were to agree, they might end up converging on the wrong set of regulations. This is not just a hypothetical possibility. The Basel process, viewed until recently as the apogee of international financial co-operation, has been compromised by the inadequacies of the bank-capital agreements it has produced. Basel 1 ended up encouraging risky short-term borrowing, whereas Basel 2’s reliance on credit ratings and banks’ own models to generate risk weights for capital requirements is clearly inappropriate in light of recent experience. By neglecting the macro-prudential aspect of regulation—the possibility that individual banks may appear sound while the system as a whole is unsafe—these agreements have, if anything, magnified systemic risks.

I agree with Rodrik.  Regulation on such a large scale poses an overwhelming epistemic problem.  Even if you believe that some form of financial regulation is desirable (which I do), the real question is: What makes a good regulatory regime?  A lot of commentators argue that we need “creative regulation,” or “smart regulation,” or “not more regulation, but more effective regulation,” but few offer details as to what these regulations should look like.  The reason for this is that financial markets are really complicated and constantly changing; no one can know exactly how they should be regulated.  As Rodrik points out, smart people thought the Basel II regime was sound.

And all of that comes on top of Rodrik’s main point – that there’s no reason to think that the proper level and form of regulation are invariant across economies.  Countries differ in the sophistication of their financial markets, in their integration into the global market, in their capacity to implement and enforce regulations, and in the purposes they hope to achieve through participation in financial markets.  Why should we expect a single regime to accommodate all of these differences?  And why should we embrace such an approach, given that the current crisis – to the extent that it has a basis in regulatory failures – is mainly rooted in the financial affairs of a small set of countries?

From both of those perspectives, it makes more sense to allow countries to define their own financial regulatory regimes within a very loose international framework.  This is not inconsistent with the creation of central international authorities to deal with crisis situations.  In their critiques of Rodrik’s argument, both Mark Thoma and Brad DeLong emphasize the need for a global lender of last resort (e.g. a beefed-up IMF) to deal with global crises ex post.  Such an institution may or may not be desirable, but there is no reason that it could not exist within a decentralized system of national-level regimes for regulating financial markets during normal economic times.

I do not think that a significant move toward strict global regulation is likely unless the current crisis really does turn out to be a The Great Depression II.  As Rodrik says, such a global framework is, for now, politically infeasible in addition to being imprudent and undesirable.  Nevertheless, if a major push for this kind of thing does emerge (I think Rodrik overstates the degree to which it is even being considered right now), I think it would be a terrible development.  At the end of his response, Thoma argues:

Basel II shows that regulators can get policy wrong, [but] I hope we have the capacity to learn from our mistakes and improve over time. The question here, for me, isn’t whether we’ve ever gotten it wrong, it’s whether we have learned enough from our past mistakes to move the regulatory ball forward, and whether, even if it’s not perfect this time, it is nonetheless an improvement that sets the stage for even better structures in the future.

To me, the fact that regulators can get it policy wrong – indeed, are likely to get the policy wrong, in my view – is a good reason not to take the huge risk of imposing a one-size-fits-all regulatory regime on the global financial markets.  This is especially true if standardization (e.g. of risk assessment tools, asset valuation tools, etc.) is likely to amplify systemic risk rather than dampen it.  A decentralized approach would avoid these pitfalls while allowing for regulatory experimentation.

Edit: In my second paragraph, I think I overstate the extent to which people propose regulation without providing concrete plans.  I think it is true of a lot of commentators, but I have seen some proposals that go a bit more in-depth.  They typically come from academics (e.g. Ben Bernanke, Mark Thoma; I’ll find some links later).  However, I think my point still stands because even when people provide details, the proposals tend to be simple things like extending the scope of capital adequacy requirements — a good idea, to be sure, but it’s not clear to me that it would have prevented the financial crisis, which is (in my view) attributable to a set of severe information problems rather than regulatory failure alone.  Once proposals get more complex than that, we are into murky waters in which it’s very hard to know what the effects of regulations will be.

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Written by Alex

March 15, 2009 at 6:43 pm

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