Magazine article Economic Review , Vol. 40, No. 12
What I would like to talk about today is the changing financial landscape as we emerge from the 2007 crisis, particularly in the context of the future of financial regulation. As someone put it rather well, "the financial system before the crisis was ill-managed, irresponsible, highly concentrated and undercapitalized, ridden with conflicts of interest and benefiting from implicit state guarantees. What is emerging is a slightly better capitalized financial sector, but one even more concentrated and benefiting from explicit state guarantees. Can this be called progress?"
As one contemplates the lessons of the crisis, and the reasons for the prolonged period of financial instability, the foremost thing that comes to mind is the role of central banks in safeguarding and maintaining financial stability, in addition to their primary objective of ensuring price stability. Central banks, whether or not responsible for the regulation of any component of the financial sector, nevertheless have a crucial role in safeguarding financial stability given that monetary and financial stability are closely linked, not in the least through the lender of last resort function. Since monetary policy transmission signals work through the channels of financial markets and bank-based intermediation, this link is even more crucial. The rapid succession of bank failures during the crisis reinforced the realization that there is no institution, besides the central bank, that can create liquidity quickly in a crisis, and with an eye on both monetary and financial stability, can take necessary actions to preempt and prevent systemic risk.
As the crisis has shown, systemic risk is THE risk financial regulation failed to capture. It is now a well established fact that supervising and regulating individual firms does not ensure that the whole system is resilient per se. Micro-level prudential regulation is not a substitute for a macro-prudential policy.
Effective financial Regulation, while not apanacea for all ills, has a definitive role to play in preempting systemic risk, and mitigating the potential impact of events leading to a crisis when it happens. While concerns have been highlighted about the negative implications of over-regulation, it needs to be pointed out that the upheaval caused by the crisis calls for more appropriate regulation, and not just more regulations perse.
In its capacity as the regulator of the banking sector, State Bank of Pakistan has shifted its focus from a rule-based regulatory approach to a principle-based regulatory framework. While the financial regulatory framework in Pakistan has evolved considerably over they ears, and is responsive to developments in its operating environment, we can still benefit from some of the debates and issues currently under contemplation in the global financial system.
Hence in my talk I would particularly like to focus on some issues where debate has emerged in the post-crisis era, and which are also pertinent for the ongoing implementation of financial sector reforms in Pakistan
The optimal regulatory model
The current financial crisis has brought forth several shortcomings of the international financial architecture. In particular, the 'light touch' model of financial regulation in vogue in advanced economies is seen to be one of the key reasons for the magnitude and protracted duration of the crisis. In the process of an in-depth analysis of the modalities of financial regulation as practiced by western economies, several factors have come to light. Among other things, successively unfolding events since August 2007 have generated a debate on the optimal model of financial regulation. The concept of a separate, stand-alone regulator of the financial sector, adopted among others by Australia in 1998 (Australian Prudential Regulations Authority APRA), and consequently by the UK in the form of a Financial Services Authority (FSA), was tested severely with the collapse of Northern Rock, pic in November 2007. …