Academic journal article
By Marshall, David; Venkataraman, Subu
Chicago Fed Letter , No. 104
Traditionally, government regulation in the United States follows a straight forward command approach. The government states the desired activities of the regulated firm, the allowable actions, and the prohibited actions. The firm is punished if it violates these strictures. Regulatory economists have identified many problems with this approach. First, there is the problem of asymmetry in information: Regulations cannot be enforced if they require information from the firm that the regulator cannot elicit reliably and at reasonable cost.
Second, there is the problem of asymmetry in expertise Regulated firms have far more expertise in their industry than regulators. The firm's management may know how to achieve regulators' goals at a lower cost than would be permitted by the regulations. Unfortunately, the command approach rarely gives management the flexibility to carry out these cheaper approaches.
A third problem is that of implementation: Complex regulations are difficult to implement. As a practical matter, command regulations must be simpler than the activity they regulate. The result is "one-size-fits-all" rules, which are either overly restrictive and heavy-handed or not strong enough to achieve public policy goals. Finally, the command approach is often subject to the law of unintended consequences: The command regulations may induce unintended perverse behavior by the regulated firm.
In response to the flaws in command regulation, a new approach to regulation has evolved. "Incentive-compatible" regulation seeks to align the incentives of regulated firms with regulatory goals. Appropriately designed regulatory structures cause the firm to internalize regulatory objectives. With their superior access to information and expertise, firms can further the public interest more effectively and more cheaply than under the command approach. Incentive-compatible regulation is generally preferred by regulated firms, since it cedes them a degree of autonomy not permitted in the command approach. The firm can choose the least burdensome way of meeting the regulator's goals. Competition insures that firms achieve social goals at minimum cost.
As an example of incentive-compatible regulation, this Fed Letter describes the evolution in approaches for determining a bank's regulatory capital for market risk. By "market risk," we mean the risk of losses to the bank from price movements in financial markets. Over the past 15 years, trading in financial markets has become a significant activity for large commercial banks (those with total assets in excess of $100 billion). In 1979, only 1.3% of these banks' assets were actively traded financial instruments. By 1994, this had grown to 13.2%.1 Bank capital, and, ultimately, the Bank Insurance Fund, is at risk if the value of this trading book falls rapidly due to a precipitous change in financial market prices. Bank observers have suggested that the risk to banks may be exacerbated by the increased use of derivatives.2 While derivative securities can be a risk-reducing tool, they also offer an inexpensive way to construct a highly leveraged asset position, which is particularly vulnerable to rapid movements in financial markets. For example, the collapse of Barings Bank last year was precipitated by a high-stakes bet on the direction of Japanese stock prices, using financial derivatives traded on exchanges in Singapore and Osaka.
Proposed capital standards for market risk
A number of approaches have been proposed for setting regulatory capital levels against market risk. One of the first was proposed in April 1993 by the Basel Committee on Banking Supervision. Known as the standardized approach, this proposal followed the conventional philosophy of command regulation. It divides trading book assets into different risk classes, and assesses a fixed capital charge against each class.
The standardized approach suffers from asymmetry both in information and in risk-assessment expertise between banks and regulators. …