Institute for Research in Economic and Fiscal issues

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Transnational financial regulation: a fix worse than the problem

The global financial crisis engendered panic in politicians worldwide. The reaction of the G20 was to move towards harmonization of financial regulation, particularly through what they regarded as a strengthening of the Basel Accords. Yet the risk was that global regulations threaten to make the next crisis truly global in effect. Harmonized regulations actually produce in some countries a systemic risk that did not exist before.

By Iain Murray

Competitive Enterprise Institute

Basel I and II did nothing to avert the global financial crisis. Indeed, they may have exacerbated both the initial crisis and failures in response to the crisis. The Basel Accords shifted a lot of activity off balance sheet and, by their laughable rating of sovereign debt as being zero risk, encouraged the nationalization of a lot of private debt.

Basel III doesn’t really address these failings, instead mainly adding another layer of complexity. Basel I was thirty pages in length, and was translated into US law in 18 pages and into UK law in 13 pages. Basel III, however, has engendered over 1,000 pages of law in both countries. US Bank reporting has swollen from 547 columns in a spreadsheet in 1986 to 2,271 columns in 2011. UK banks have to fill in 7500 cells of data, and further transnational regulation could increase that to over 30,000 cells in 60 different reports.

The very idea of these regulations being implemented universally is also an increase in risk. Previous crises have been mitigated somewhat by the countercyclical aspects of some economies. Canada and Australia weathered the financial storm well because they had put in place better procedures than the countries who suffered the most.

If all countries are harmonized, however, the risk of financial crisis to the world economy becomes that much greater. There are no safe harbours to retreat to when the storm returns.

Virtually all financial regulation is about fighting the last war. Regulations are passed in the wake of a crisis aimed at preventing another similar crisis, but financial crises, with the exception of sovereign defaults, are actually remarkably dissimilar, and in virtually all cases the previous regulation plays a role in causing the next crisis.

We know that poor monetary policy choices and "non-financial" regulation (such as attempts to boost homeownership around the world beyond market levels) contribute to financial crises, and are themselves rarely addressed in financial regulation.

Financial regulation also tends to increase moral hazard, making financiers and regulators alike more complacent and less attentive to warning signs, or more willing to take risks. The classic example of this is deposit insurance, which allows financiers to make riskier bets with depositors’ funds, and moreover encourages depositors to allow this.

A similar situation occurs when banks that are “too big to fail”. They grow big in the knowledge that they will be saved, and moreover, in the knowledge that things like bonus structures will tend to be honoured in the event of a bailout, as happened repeatedly in the American TARP bailouts.

There are significant public choice aspects to financial regulation. The regulators are much more likely to favour the financial colleagues they work with every day over the interests of the general public. This is why TARP ended up as a rescue of Wall Street and helped line the pockets of those whose mistakes should have led to the creative destruction of their firms.

Another thing that has become apparent in recent years is that finance is not “normal”. This means that financial events are not distributed according to the normal distribution, but rather have extremely fat tails. Yet most regulation is based on the idea of a normal distribution of events, thus exacerbating the fatal conceit aspects of regulation.

Private (rather than government) monitoring of financial institutions enhances bank performance significantly. The more attention investors and depositors pay to the activities of the bank, the better that bank’s performance will be.

The free market response to the threats of regulation to the job of finance - authorizing innovation - becomes clear. We must work to persuade people that we oppose increased regulation because it increases moral hazard to the extent that consumers are all too likely to suffer as a result. Jobs will be lost, wages will be lowered, vulnerable people will be taken advantage of - all because regulators are doing their job.

We should instead be looking for ways to enhance private monitoring of financial institutions. One way is to significantly reduce government guarantees. Rather than increasing deposit insurance (as the Dodd-Frank Act did) we should be lowering it, making clear to depositors that they have a compelling interest in forcing private disclosure of risky banking activities.

What we do not need is some sort of regulator for the regulators, aimed at telling policy-makers where the regulators are going wrong. This falls foul of Juvenal’s warning from the First Century AD - Quis custodiet ipsos custodes? Who watches the watchmen?

Concerning Basel the free-market response should be to urge the G20 governments to recognize the risks of increased complexity and harmonization through Pillar One - regulatory rules - and to abandon attempts to tighten them, in favour of a concomitant strengthening of the other two pillars - supervisory discretion and market discipline.

The Bank of England has declared that its new supervisory regime will be based on fewer but more experienced supervisors operating to a smaller, less detailed, more understandable rule book, or to allow less to deliver more.

With these two changes, market discipline will itself be strengthened. Moral hazard will be reduced and private monitoring will increase, leading in turn to better bank performance.

Finally, when it comes to the problem of US regulatory imperialism, the solution is a diplomatic one. All of us have a role to play in urging our governments to resist these attempts by the US to shove Dodd-Frank down your throat. At over two thousand pages, that’s quite a choking hazard.

This is an edited summary of a presentation at the European Resource Bank (Brussels, Sept 2012).

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