Financial Regulation

Why, How and Where Now?

Charles Goodhart, Philipp Hartmann, David T. Llewellyn, Liliana Rojas-Suarez, Steven Weisbrod

• Publisher: Routledge
• Year: 2013
• ISBN:
  9781135116392
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Financial Regulation presents an important restatement of the purposes and objectives of financial regulation. The authors provide details and data on the scale, nature and costs of regulatory problems around the world, and look at what sort of countries and sectors require special attention and policies. Key topics covered include:
* the need to recast the form of regulation
* incentive structures for financial regulation
* proportionality
* new techniques for risk management
* regulation in emerging countries
* crisis management
* prospects for financial regulation in the future.

1 The rationale for regulation

A. The scale of the problem

Financial systems in most countries of the world have been shown to have had a fragile structure in recent decades. It is in that context that we aim to reassess the rationale, mechanisms and modalities of financial regulation.

A review of the experiences since 1980 of the 181 current Fund [IMF] member countries reveals that 133 have experienced significant banking sector problems at some stage during the past fifteen years [1980 — Spring 1996]. … Two general classes [of problem] are identified: ‘crisis’ (41 instances in 36 countries) and ‘significant’ problems (108 instances).

Thus begins a recent study by IMF economists entitled Bank Soundness and Macroeconomic Policy¹ (see Figure A1.1 and Table A1.1 in the Appendix to this chapter). This outcome is worse than in any other similar period since the Great Depression in the 1930s. The macroeconomic effect of such banking crises has in many cases been so severe as to amount to a sizeable reduction in GDP (see Table 1.2 the Appendix).

Are these problems more severe in industrial or in developing countries? How do emerging and transitional banking markets perform? We have adjusted and further broken down the IMF data to get a more differentiated picture of banking problems (see Table 1.3 in the Appendix), and it turns out that only a slightly larger share of all developing countries have faced a ‘crisis’ (20 per cent) or ‘significant’ problems (53 per cent) when compared with industrial countries (crisis: 17 per cent, significant problems: 52 per cent). However, the greater riskiness of banking systems in developing countries becomes more pronounced (crisis: 23 per cent, significant problems: 59 per cent) when twenty-two small island states are removed from the sample.

We also defined three subgroups for the developing world: emerging countries, economies in transition, and oil-exporting countries.² In fact, ten out of sixteen emerging economies, almost two-thirds of the total, have experienced a crisis over the sample period, and not a single one escaped without any banking problems. Similarly, four-fifths of twenty-four transition economies experienced significant problems, although real crises seem to be less frequent in this group than in emerging markets. From this perspective, oil-exporting developing countries seem to have faced fewer problems: ten out of thirteen did not receive any negative entry by the IMF economists.

The main causes of these problems have been those that have traditionally attended commercial banking since its historical beginnings — poor credit control, connected lending, insufficient liquidity and capital — in short, poor internal governance (see Table A1.4 in the Appendix). This record suggests that most countries, especially the emerging and transitional countries, may need enhanced and improved external supervision to reinforce internal controls. Goldstein (1997) has recently put forward a set of proposals for such supervision in emerging countries. We discuss them further in Chapter 6.

B. The case for external regulation, and the need to make such a case

Bank failures around the world in recent years have been common, large and expensive. While they were, perhaps, larger than generally appreciated, their existence does not, of itself, necessarily justify the attention currently being given to the reinforcement of financial regulation and supervision. Indeed, many ‘liberal’ academic economists, e.g. supporters of free banking such as Dowd³ and Benston and Kaufman⁴, would attribute many of these crises and problems to the (indirectly malign) effects of regulatory efforts — perhaps the most extreme example of iatrogenesis (medically induced illness) ever known.

Interposing regulation and supervision into an otherwise free-market context weakens the incentives for the owners and managers to monitor and control themselves, and for their clients to exercise due diligence. Expectations are fostered among both clients and owners/managers about the standards of safety and propriety that supervisors should ensure in controlled institutions, but these expectations cannot be satisfied without such an expensive, intrusive and inflexible system that it would be wrong to try to install. In part because one rule can never fit all, regulations inevitably distort the economic outcome, possibly so much that the end result is worse than the unregulated starting point.

Indeed, the numerous additional problems with a highly prescriptive regulatory regime are outlined by Llewellyn (1996: 23–4):

• An excessive degree of prescription may bring the regulatory regime into disrepute because it is perceived by the industry as being excessive, with many redundant rules.
• Risks are often too complex to be covered by simple rules.
• Balance sheet rules reflect the position of an institution only at a particular point in time, although its position can change substantially within a short period.
• An inflexible approach based on a detailed rule book has the effect of impeding firms from choosing their own least-cost way of meeting regulatory objectives, and also thereby stifles financial innovation.
• A prescriptive regime tends in practice to focus upon firms' processes, rather than outcomes, and the ultimate objectives of regulation. Thus, the rules may become the focus, rather than the objectives. It can give rise to a perverse culture of ‘box ticking’ by firms. The letter of the law may be obeyed at the cost of the spirit.
• A prescriptive approach is inclined towards rules escalation (whereby more rules are added over time, but few are withdrawn).
• Regulation may create a confrontational relationship between the regulator and the regulated firms, or alternatively cause firms to overreact, engaging in excessive efforts at internal compliance out of fear of being challenged by the regulator.
• Forcing a high degree of conformity on regulated firms causes an information loss. If firms are given leeway in satisfying the regulator's objectives and principles, more is learned about consumer preferences in regulation, about how different behaviour affects the objectives, and about the properties of different rules, etc.
• In the interest of ‘competitive neutrality’ rules may be applied equally to all firms, although firms may be sufficiently heterogeneous to warrant a different approach. Treating as equal firms that in practice are not equal is not competitive neutrality, and it reduces the scope for legitimate differentiations.
• A highly prescriptive rules approach may prove to be inflexible and not sufficiently responsive to market conditions.
• There is a potential moral hazard, because firms may assume that, if something is not explicitly covered in the regulations, there is no regulatory dimension to it.

These concerns are not so much about regulation itself, but about externally imposed regulation, as opposed to self-regulation. As Coase (1988) has emphasised, free markets require considerable internal infrastructure and self-regulation to function efficiently with minimal transaction costs. Issues such as the provision of information, the identification and establishment of the roles of the various market agents and dealers, how a deal is to be made, registered, settled and paid, and the resolution of market discrepancies and failures, all have to be agreed upon and codified. While the majority of such market regulations are, indeed, the outcome of private agreement among those involved, private regulations do need the underlying support of commercial and contract law to provide sanctions and to prevent opportunistic behaviour. This is discussed further in Chapter 3.

Given, then, the common failings of externally imposed regulation, why do we not rely on private self-regulation, reinforced by common, commercial and contract law? One reason is that public pressure may not allow that to happen. Whatever the social costs and benefits of an externally imposed system of regulation may be, public revulsion at the effects and outcome of failures in unregulated financial systems can force the establishment of systems of deposit insurance and external regulation, no matter what the reservations of the authorities may be. Those who are invested with the responsibility for supervision are often aware of the poison within the chalice.

But the case for external regulation (in addition to, and partly in place of, private self-regulation) does not rest just on surrender to public pressure; and, if it did, such pressure should be resisted. Instead, the case depends on circumstances in which the private sector, left to itself, produces market failure, or at least suboptimal results, which are arguably worse than public sector regulation, even with all the biases and failings that such regulation may entail.⁵

The three main reasons for public sector regulation are:

1 To protect the customer against monopolistic exploitation.

2 To provide smaller, retail (less informed) clients with protection.

3 To ensure systemic stability.

(i) Protection against monopolies

The first case for intervention arises when there is a private sector monopoly, or a collusive and antisocial oligopoly. Such conditions are muc...

Table of contents

• Cover
• Half Title
• Full Title
• Copyright
• Contents
• List of figures
• List of tables
• Notes on authors
• Foreword
• Acknowledgements
• Introduction
• 1 The rationale for regulation
• 2 Barings and the need to recast the form of external regulation in developed countries
• 3 Incentive structures for financial regulation
• 4 Proportionality
• 5 The new techniques for risk management
• 6 Regulation in developing countries
• 7 Managing financial crises in industrial and developing countries
• 8 The institutional structure of financial regulation
• 9 Summary of policy conclusions
• Appendix: Central Bank Governors' Symposium participants
• Notes
• Bibliography
• Index