Finance: Research, Policy and Anecdotes

Future challenges for financial regulation

A discussion that has dominated the regulatory reform debate is that on the appropriate regulatory framework. Any post-crisis regulatory reform solves the problems of the previous crisis, but the known unknowns and, worse, the unknown unknowns, are awaiting.  At a time when not only bankers are growing desperate on a regulatory framework that no longer fills binders but whole rooms, the question on basic principles of regulation becomes again urgent.  As the U.S. might move towards either dismantling the Dodd-Frank Act or at least modifying it and as the UK considers its options for the City after the Brexit, this debate will revive soon.   There are certainly no easy answers to that (so if you are looking for them, please stop reading now), but there are clearly some general principles as Elena Carletti, Itay Goldstein and I have outlined in a literature survey cum think piece we recently published, as well as in an accompanying Vox column.  Here are our main conclusions:

First, revisit the necessity for complexity. As the financial system gets more and more complex and sophisticated, there is a tendency to make regulation also more complex to address some of the newly emerging issues. However, this may backfire. First, increasing the complexity of the financial regulation may provide the industry players with stronger incentives to make their institutions more complex. Second, complex financial regulation opens the door for manipulation of rules on the side of financial institutions and investors, as shown by empirical evidence. Hence, it is important to complement ever increasing complex regulation with some simple rules. For example, going back to a simple leverage ratio in the new Basel accord in addition to risk-weighted capital requirements is a step in the right direction.  Similarly, while it might make sense to apply price-based regulation to banks that want to be active across different business lines (as in the form of ring-fencing), outright prohibitions might be needed in other cases (as is the case for the Volcker Rule).

Second, there is the need for a stronger focus on macro-prudential policies, in addition to the traditional micro-prudential policies. New policy measures such as bank stress tests and capital requirements that depend on the aggregate state of the economy are steps in the right direction in trying to take the systemic risk aspect into account. But, clearly a lot of work is still needed in better measuring systemic risk and assessing the effectiveness of macro-prudential policy measures.  Clearly an area of huge research opportunities.

Third, resolution matters! The experience of the recent crises shows that it is critical to have frameworks in place to resolve financial intermediaries in a way that minimises disruptions for the rest of the financial system and the real economy, while allocating losses according to creditor ranking. An incentive-compatible resolution framework has therefore not only important effects ex-post, i.e. in the case of failure, but also important ex-ante incentive effects for risk-decision takers. This also implies that a lot of attention and preparation is needed ahead of time before the actual failure of big and complex institutions. Imposing living wills and requiring bail-in strategies in case of failures are indeed important steps that will make institutions think more about the event of the failure and internalise better the risks that they are imposing on the system.   However, this has to be matched with the acknowledgement that there will be never a “no more bail-outs” and there will always be institutions that are too important to close completely.

Fourth, we need  a dynamic and forward looking approach to regulation that stands ready to adjust the regulatory perimeter. The problem with regulatory reforms in the past was that it always addressed the regulatory gaps exposed in the most recent crises. But, as regulators tightened restrictions on institutions that have had problems before, activity and risk taking shifted to other institutions and markets, often outside the regulatory perimeter. It is thus important to think about the system as a whole and understand new innovations as they happen. It is important to remember that regulating one type of institution will lead to the emergence of others, and so design regulation in a forward looking way.  This would imply that the regulatory perimeter has to be adjusted over time and that the focus of prudential regulation (both micro- and macro-prudential) might have to shift over time as new sources of systemic risks arise.

On a final note, as I discussed these topics in a recent panel discussion at the World Bank in Washington DC, another important issue came up: personal liability of bankers! There is historic evidence that this has reduced failure and losses in past times (though in less complex banking systems) - maybe an idea to revisit? It would provide the obvious symmetry to bonuses for bankers – let them pay for their mistakes!