On Prudential Regulation: To Regulate Foreign or Domestic Intermediation?

Article excerpt

In traditional Chinese medicine, the doctor is paid as long as the patient is healthy. The patient comes in four times a year for a checkup, with adjusted lifestyle recommendations. Payment is stopped once the patient is ill. In the US, as long as the economy is healthy, "the financial doctor" in the form of the prudential regulator is considered redundant. Moreover, the prudential regulator is frequently viewed as a spoiler who inhibits growth and development. This is the paradox of prudential regulations in a capitalist economy--the better the regulator's performance, the lower the demand for its services. The success of the regulator or a prolonged period of economic tranquility leads to complacency, reducing the demand for his services, inducing under-regulation, which leads to a financial calamity. While the identity of economic actors that benefited directly from crisis avoidance is unknown, the cost and the cumbrance of regulations are transparent. Hence, crises that have been avoided are imperceptible and are underrepresented in the political discourse, and the demand for regulation declines during prolonged good times, thereby increasing the ultimate cost of eventual crises.

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The 1990s was a prolonged period of what was perceived as the 'great moderation' of the global economy, a period of remarkable decline in the variability of both output and inflation, reducing the demand for financial regulations. This may explain the growing acceptance during the 1990s-2000s of Greenspan's seductive "market-stabilizing private regulatory forces" doctrine. Deepening global financial integration, and the growing confidence that global risk diversification, reduced systemic risk sharply lowered the risk premium. The successful private bailout of Long-Term Capital Management (LTCM) in 1998 was taken as a vindication of the efficacy of "market-stabilizing private regulatory forces," where the main role of the Fed is providing coordination services among the private parties involved in the bailout. However, the resultant complacency provided the background for the onset of the present crisis--calamity akin to a global LTCM on steroids. This time, however, the crisis is too big to be dealt with by private bailouts. The present challenge of rethinking the global financial architecture is to upgrade regulations in ways that recognize the paradox of prudential regulations during times of deepening financial integration, while taking into account the emergence of new domestic and foreign players, and new exotic financial instruments.

While the seeds of the present crisis were mostly homegrown, international flows of capital magnified its costs. Although it is a mistake to single out any class of foreign players as the key domino, the crisis awakened us to the need to overhaul global financial regulations. Global financial integration produces the by-product of "regulatory arbitrage": capital tends to flow to under-regulated countries, frequently resulting in excessive risk taking, in anticipation of future bailouts. Dealing with "regulatory arbitrage" requires coordinated prudential regulations that should apply as equally as possible to domestic and foreign players. Such regulations should be tailored to the risk category and exposure of each player above a minimum size, independent of the player's nationality. This would require a major overhaul of the information gathered by regulators and provide the benefit of setting a minimum global standard on information disclosure, as well as margin and leverage requirements on all financial players above a minimum size.

A coordinated globalized prudential regulation, by increasing the cost of prudential deregulation, would mitigate the temptation to under-regulate during prolonged good times, thus adding a side benefit. Thereby, it would act like Odysseus' solution to the temptations of the Sirens: sealing sailors' ears with wax. We review in greater detail the need for comprehensive prudential regulation, and discuss possible implications on the investment practices of sovereign wealth funds (SWFs)--savings funds controlled by sovereign governments that hold and manage foreign assets--and international hedge funds. …