On the efficacy of financial regulations.

Abstract

Regulatory failures have been a significant contributor to the financial crisis, but that does not automatically mean more regulation is called for. The crisis happened because fi nancial institutions and the whole economy used seemingly infi nite amounts of cheap credit to create an asset price bubble. The banks played their part by creating all these complex structured products that continue causing difficulties. They did this under direct regulatory oversight. Such excessive credit expansion is how most financial crises have played out throughout history. The exact same process can be prevented from happening in the future, but surely the next crisis will take a different form. It will be something completely unforeseen. One cannot regulate against such unforeseen events. The crisis has its roots in the most regulated parts of the financial system, the banks, whilst the least regulated part, the hedge funds, are mostly innocent. Is the problem lack of regulation? Or is the problem lack of understanding on how to regulate financial institutions properly? Depending upon the answer to the question, the correct approach to future financial regulations will be very different. The unique element this time around has been the extensive use of statistical models to forecast prices, and risk as well as to price complex assets. It was the models that failed. Such models embed an assumption of risk being exogenous; market participants react to the financial system but do not change it. In practice, this is nonsense. Market participants, especially in a crisis, receive the same signals and react in a similar way; they exert significant price impact resulting in risk being endogenous. This implies financial risk models are the least reliable when we need them the most and that regulation by risk sensitivity, such as risk sensitive bank capital, may increase financial instability. The root causes of the crisis are the same as in most financial crises throughout history. These crises have happened under a wide range of regulatory mechanisms. Blaming the crisis on a narrow set of obvious regulatory causes, such as bonuses, hedge funds, universal banking, shadow banking, structured credit, lack of regulations, inadequate risk management is attacking a straw man. It takes the focus away from the necessary detailed examination of the causes of fi nancial instability, which is the only way to design effective regulatory mechanisms. We do not clearly understand what went wrong, and know even less how to design regulations to prevent such episodes from happening in the future, whilst maintaining the effi ciency of the financial system. This is why it would be preferable to study what went wrong and then in a few years carefully change regulations at a time when we know more. There is no hurry, we still haven’t solved this crisis and the next one will not come immediately after the current crisis. The costs of inappropriate regulations are high and we do have the time to wait.