A Practical Approach to the
Regulation of Risk
A peculiar characteristic of financial regulation today, and one of the causes of its failure, has been the divergence of theory and practice.1 Recent proposals by regulatory and banking lobbies appear to be continuing this divergence. In theory, it is generally accepted that the core purpose of financial regulation is to mitigate systemic risks, such as a global credit crunch. In practice, however, the regulatory rules are focused entirely on risk-taking by individual firms.
It is a fallacy of composition to think that if good behavior is encouraged at the company level, the system will inevitably look after itself. One of the striking things about the report requested by the Swiss Federal Banking Commission into the facts leading to UBS’s subprime losses is that much of what UBS did to get into difficulty was considered to be best practice for individual firms. Banks put their resources in places where their risk-management systems, using publicly available data, told them it was safe, generating systemically large concentrations.
As environmental regulators have found, formulating practical “systemic” policies is far from easy. But giving up is not an option. When confronted with this point, regulators have asked us, “What would systemic regulation look like?” The following three proposals provide a flavor.
• While financial institutions are encouraged by supervisors to conduct thousands of stress tests, few are conducted by the regulators on a systemwide scale. If it is possible to have systemwide stress tests on the impact of Y2K, or on avian flu, why not on liquidity? The regulator