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It is time for a reappraisal of the basic principles of financial regulation

Today’s financial regulation is founded on the assumption that making each bank safe makes the system safe. This fallacy of composition goes a long way towards explaining how global finance became so fragile without sounding regulatory alarm bells. This column argues that mitigating the costs of financial crises necessitates taking a macroprudential perspective to complement the existing microprudential rules.

The regulatory system stands accused of having failed to provide any check or barrier against the boom-and-bust cycle in the financial system. It was largely a bystander during the build-up of leverage and the erosion of credit standards in the credit boom and has been largely powerless as the boom has turned to bust with a devastating impact on the real economy.

How did we reach this state of affairs?  

It was not for want of the quantity of financial regulation, if quantity be measured in terms of thickness of the rule books. The Basel II rules for banking regulation famously generated reams of paper, all the while sapping the energy and patience of the hapless cadre of dedicated officials locked in detailed discussions on the latest bell or whistle to be attached to the rules.

Microprudential versus macroprudential perspectives

Basel II rests on the principle that the purpose of regulation is to ensure the soundness of individual institutions against the risk of loss on their assets. Of course, it is a truism that ensuring the soundness of each individual institution ensures the soundness of the system as a whole. But for this proposition to be a good prescription for policy, actions that enhance the soundness of a particular institution should promote overall stability. However, the proposition is vulnerable to the fallacy of composition. It is possible, indeed often likely, that attempts by individual institutions to remain solvent can push the system to collapse.

Fallacy of composition

Consider Figure 1 below. Bank 1 has borrowed from Bank 2. Bank 2 has other assets, as well as its loans to Bank 1. One day, Bank 2 suffers credit losses on these other loans, depleting its equity capital. The prudent course of action for Bank 2 is to reduce its overall lending, including its lending to Bank 1.

Figure 1. Prudent shedding vs a run


But a prudent shedding of lending by Bank 2 is a run when seen by Bank 1. Arguably, this type of run is what happened to the UK bank Northern Rock, which failed in 2007, as well as to the US securities houses Bear Stearns and Lehman Brothers, both of which suffered crippling runs in 2008.

In this simple setting, it is clear how misguided it would be to induce even greater recoiling from risk on the part of Bank 2 when faced with shocks. But a greater recoiling from risk is exactly what the Basel II rules have managed to hard-wire into the financial system.

Systemic implications of recoiling from risk

In the name of modernity and price-sensitive risk management, Bank 2 is encouraged to load up on exposures when measured risks are low, only to shed them as fast as it can when risks materialise, irrespective of the consequences of the rest of the system. Unfortunately, the recoiling from risk by one institution generates greater materialised risk for others. Put differently, there are pervasive externalities in the financial system. What we are witnessing now in the global financial crisis is that these externalities also extend to the real economy. The loading up and subsequent shedding of risks show up in the leverage cycle of banks, as shown by Figure 2 which shows how each major crisis in recent years has been preceded by a rapid increase in leverage of banks (Adrian and Shin, 2009).

Figure 2. US Primary Dealer Mean Leverage (June 1986 – Sept 2008)


Is there a better way? Pigou to the rescue

One textbook prescription to deal with externalities is to impose Pigovian taxes to internalise those externalities. For the smoky factory located next to the laundry, the externality is the pollution emitted by the factory that soils the washing laid out to dry by the laundry. In this case, calculation of marginal costs will enter into the appropriate Pigovian tax on the factory.

How far can we take the exercise of imposing Pigovian taxes to the financial context?  In the abstract, we could assign a “systemic impact factor” to each entity in the financial system that attempts to gauge the extent of the spillover effects. For instance, the systemic impact factor could be calculated through the type of fixed point calculation that is used in journal citations ratings or for calculating impact weights that Google uses for ranking websites. The impact weights for journals are such that a high-impact journal receives many citations from other high-impact journals. Similarly, the rankings of websites have the feature that a high-ranking website has links that point to it from other high-ranking websites.

In the financial context, a high-impact bank is one that imposes costs on other high-impact banks (Morris and Shin, 2008).

Proposals in the Geneva Report

In practice, however, the rules governing financial regulation will need to be based on indicators that are more directly measured. The task is to find proxies for the underlying externalities that can reliably serve as the informational basis for regulation.

This year’s Geneva Report on the World Economy (Brunnermeier et al., 2009) argues for a fundamental reappraisal of the basis for financial regulation and sets out a proposal on how the existing Basel II regulations should be modified to incorporate macroprudential goals – in particular, how the existing Basel II capital requirements ought to be modified by the multiplication by a systemic impact coefficient that depends on indicators of potential spillovers.

Macroprudential indicators

Our list of indicators includes recent trends in leverage, asset growth, and the maturity mismatch between assets and liabilities. Each of these elements capture (albeit imperfectly) aspects of the externalities that one institution imposes on the system. At the same time, our goal is to preserve as much as possible that is good about the microprudential rationale for financial regulation. Our hope is that familiarity of the starting point (the existing Basel II framework) will make the task of re-orienting the regulatory framework appear less daunting and less wrenching in terms of implementation. But the underlying rationale for our proposals could not be more different from the Basel II rules themselves.

The Basel II process illustrates how changes in regulation are typically achieved incrementally. Even such measures as may have seemed to involve a discrete jump in the regulatory process, such as the passage of the original 1988 Basel I Accord turn out, on closer inspection, to have been largely an attempt to agree on, and to harmonise, pre-existing ‘best practices’ in the key nation states, without much overt attempt to rationalise them against fundamental principles, or underlying theory. Incremental change has the strength that it builds on accumulated wisdom. But it is possible for such an incremental, and generally reactive, process to migrate over time in wrong, or just inferior, directions. It is only with wrenching economic crises, such as the Great Depression, that there is a general willingness to review the fundamental tenets of the regulatory framework. With the global financial crisis that began in 2007, we may be experiencing another comparable shift in the collective willingness to review the foundations of regulation.

All this was known but ignored

In 2001, Jon Danielsson, Charles Goodhart, and I, together with other colleagues at the Financial Markets Group of the LSE, submitted a paper to the Basel Committee in response to a call for comments on the initial Basel II proposals. The three key planks in our argument were summarised in the executive summary in the following terms.

“The proposed regulations fail to consider the fact that risk is endogenous. Value-at-Risk can destabilise and induce crashes when they would not otherwise occur.

Heavy reliance on credit rating agencies for the standard approach to credit risk is misguided as they have been shown to provide conflicting and inconsistent forecasts of individual clients’ creditworthiness. They are unregulated and the quality of their risk estimates is largely unobservable.

Financial regulation is inherent procyclical. Our view is that this set of proposals will, overall, exacerbate this tendency significantly. In so far as the purpose of financial regulation is to reduce the likelihood of systemic crisis, these proposals will actually tend to negate, not promote this useful purpose.” (Danielsson et al. 2001)

Eight years later, these conclusions still have resonance.

Banquo’s ghost at the banquet

Back in 2001, our proposals must have been as welcome as Banquo’s ghost at Macbeth's banquet. No one likes to be told that their carefully crafted work is flawed.

The Global Financial Crisis of 2007-2008 has changed everything. The proposals of the Geneva Report are aimed at achieving a more stable financial system that works more effectively in serving the workings of the real economy to promote economic prosperity. We should seize this opportunity to put financial regulation on more secure conceptual foundations.

Editors' note: This column is a Lead Commentary on Vox's Global Crisis Debate where you can find further discussion, and where professional economists are welcome to contribute their own Commentaries on this and other crisis-linked topics.

Adrian, Tobias and Hyun Song Shin (2009) “Money, Liquidity and Monetary Policy” forthcoming in American Economic Review Papers and Proceedings.

Brunnermeier, Markus, Andrew Crockett, Charles Goodhart, Avinash Persaud and Hyun Song Shin (2009) “The Fundamental Principles of Financial Regulation”  11th Geneva Papers on the World Economy

Danielsson, Jon, Paul Embrechts, Charles Goodhart, Con Keating, Felix Muennich, Olivier Renault and Hyun Song Shin (2001) “An Academic Response to Basel II’’ Financial Market Group special paper 130, London School of Economics.

Morris, Stephen and Hyun Song Shin (2008) “Financial Regulation in a System Context” forthcoming in the Brookings Papers on Economic Activity.

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