Regulating the new financial sector
Willem Buiter
Professor of European Political Economy at the London School of Economics and formerly a member of the Monetary Policy Committee of the Bank of England and Chief Economist at the European Bank for Reconstruction and Development. CEPR Research Fellow
9 March 2009
Financial regulation is a now-or-never proposition as the sector’s lobbying power is greatly diminished. This column argues that we should embrace robust regulation now, risking over-regulation. Correcting mistakes later would be better than risking another era of “self-” or “soft-touch” regulation.
Over-regulate now
It is necessary, for political economy reasons, to rush new comprehensive regulation of the financial sector. While it would be better, holding constant the likelihood of the measures being adopted and implemented, not to act in haste, there is now a unique window of opportunity – a period of extraordinary politics, in the words of Balcerowicz – to actually get the thorough regulatory reform we need. The reason is that the private financial sector is on its uppers – down and out – and will not be able to put together much of a fight, let alone its usual boom-time massive lobbying effort to veto radical measures. It is better to over-regulate now and subsequently correct the mistakes than to risk another era of self-regulation and soft-touch under-regulation of financial markets, instruments and institutions.
Macro-prudential regulation
The objective of macro-prudential regulation is systemic financial stability. This has a number of dimensions:
Preventing or mitigating asset market and credit booms, bubbles and busts
Preventing or mitigating market illiquidity in systemically important markets
Preventing or mitigating funding illiquidity for systemically important financial institutions
Preventing or managing insolvencies of systemically important financial institutions
Other micro-prudential considerations (abuse of monopoly power; consumer protection; micro-manifestations of asymmetric information) should be left to the micro-prudential regulator(s).
Comprehensive regulation
Regulation will have to be comprehensive across instruments, institutions, markets and countries. Specifically, we must:
Regulate all systemically important highly leveraged financial enterprises, whatever they call themselves: commercial bank, investment bank, universal bank, hedge fund, SIV, CDO, private equity fund or bicycle repair shop.
Regulate all markets for systemically important financial instruments.
Regulate all systemically important financial infrastructure or plumbing: payment, clearing, settlement systems, mechanisms and platforms, and the associated provision of custodial services.
Do it all on a cross-border basis.
Self-regulation
Self-regulation is to regulation as self-importance is to importance. The notion that markets, including financial markets could be self-regulating, by properly incentivising CEOs and Boards of Directors and through market-discipline, is prima facie suspect. We decide to regulate markets because of market failure. Then we let the market regulate the market. This is an invisible hand too far. The concept of self-regulation is especially ludicrous for financial markets. Finance is trade in promises expressed in units of abstract purchasing power (money). It scales up and down ferociously quickly. If Airbus or Boeing wishes to double the size of its operations, it takes 4 or 5 years to put in place another set of assembly lines. If a bank wishes to scale its balance sheet and operations ten-fold, all it has to do is to add a zero in the right places. Given enough optimism, trust, confidence and self-confidence, financial activity can, through leverage, be scaled up alarmingly quickly. Once optimism, trust, confidence and self-confidence disappear and are replaced by pessimism, mistrust, lack of confidence and fear/panic, the scaling down of bank activities can occur even faster. Such an industry cannot be left to its own devices.
The importance of public information
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