A Better Way to Design Global Financial Regulation

By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

Economists, central bankers and politicians are pushing for effective implementation and better coordination of the new financial regulations currently under construction across the globe.  The authors, Viral Acharya and Sabri Oncu, argue in a recent VOXEU communique (Jan. 14^th) that at a time of crisis, financial regulators were forced to act on systemically important assets and liabilities, rather than focus on the individual financial institutions holding them.  A key turning point towards better regulation will be when we recognize the need for such action ahead of time, building the essential infrastructure that reduces incentives for excessive risk-taking.

A key regulatory failure behind the global financial crisis was the focus on individual rather than collective or systemic risk of financial institutions. Importantly, the main focus is not on all financial institutions as a collective group, but only on those financial institutions to be deemed systemically important.  This will divert risks to the weakly regulated or unregulated parts of shadow banking.

Ignoring the issue of regulatory arbitrage and shadow banking, the progress on the global implementation of new financial regulations has been slow.  The main reason behind this is that many systemically important financial institutions operate across borders, but there are different styles and interests of regulators in different countries.

There is a better alternative and to design global financial regulation: one is to harmonize existing regulations and is reasonably immune to the risks posed by shadow banking evolution.  The focus on individual institutions create problems on the liability side when a counterparty defaults and could create a run on other entities.  Conversely, fire sales of assets can force collateral damage on other holders of such assets.

The point is to regulate all institutions holding such assets, regardless of their home country or whether they are deemed systemically important.  It would require dedicated utilities, such as ‘clearinghouses’ for derivatives.  These utilities, operating at the level of individual assets and liabilities would deal with defaults by ensuring orderly liquidation of positions. And, recognizing that such liquidation poses significant risks, there would be limits imposed on the risk of positions in the first place such as margin requirements.

The Financial Stability Board can coordinate at the global level the setting up of such utilities and can harmonize and enforce risk management standards.  This is easier than designing regulations that operate at the level of individual institutional forms.  If shadow banking develops newer assets and liabilities, then, newer utilities would be introduced in the financial sector.  The Federal Reserve, the Bank of England and the ECB set up facilities to avoid financial collapse during the financial crisis.  These facilities were set up for systemically-important financial instruments.

Stated differently, financial regulators around the globe were forced in the midst of a crisis to act on systemically important assets and liabilities, rather than just on individual financial institutions holding them.  The key is to recognize the need for such action ahead of time and build the essential infrastructure to ensure that excessive risk-taking is discouraged and markets know that regulators have an orderly resolution plan.  This would help simplify risk management.

www.voxeu.org/article/better-way-design-global-financial