Date published: Jul 2019
SUERF Policy Note, Issue No 86
by Prasanna Gai, Malcolm Kemp, Antonio Sánchez Serrano and Isabel Schnabel
The regulatory response to the global financial crisis and broader developments in finance and society have materially expanded regulation in the financial sector. Ideally, financial regulation should be designed so that the societal benefits exceed the costs, even when they relate to different institutions. It should therefore be framed in a manner that includes a system-wide perspective and reference to systemic risk and financial stability. Excessively complex financial regulation contributes to systemic risk by (i) creating the illusion of a well-controlled system and incentivising regulated entities to game the system, (ii) by missing contingencies that are not well understood, thus being unable to address “unknown unknowns”, (iii) by making policy responses convoluted and difficult to judge, hampering public accountability, and (iv) by encouraging the transfer of risks outside the regulatory perimeter. Conversely, overly simple financial regulations are unlikely to properly address the misaligned incentives, informational asymmetries and externalities underlying the need for regulation. A transparent cost-benefit analysis, greater evidence-based design of financial regulation, and evaluations of its effectiveness are desirable actions to improve financial regulation. In addition, financial regulation should be robust in the sense of being able to cope with a variety of failure-inducing circumstances and behaviours, while not trying to offer the best-tailored response to each specific phenomenon. It thereby accounts for the interaction between Knightian uncertainty and systemic risk. The quest for robustness in financial regulation could be facilitated by adopting seven principles: adaptability, diversity, proportionality, resolvability, systemic perspective, information availability, and non-regulatory discipline. Such robust financial regulation could improve the cost-effectiveness of the regulatory outcome while reducing its complexity.
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