Document Type

Working Paper

Publication Date

2014

Keywords

financial regulation, financial system, systemic risk, macroprudential regulation, functional regulation, systemic shocks, financial crisis

Abstract

In this updated and retitled article (an earlier version being titled “The Functional Regulation of Finance”), I examine how we should think about regulating a dynamically changing financial system. Being tethered to the financial architecture at the time it is promulgated, most financial regulation is temporally flawed. Even assuming the regulation is meaningful at that time, it quickly can become outmoded without ongoing monitoring and updating.

It may be more effective to tie the regulation of a dynamically changing financial system to the system’s functions, which are less time-dependent than any specific financial architecture. This article constructs a functional framework for analyzing and designing financial regulation. Such regulation should have two goals: to correct market failures that impair the ability of the financial system’s underlying components—its firms and markets—to engage in funding and in the risk-management, behavior-monitoring, and information-processing functions related to funding; and to protect the capacity of the financial system, as a “system,” to serve as a network within which funding and its related functions can be conducted.

Using this framework, the article first identifies, and examines how “microprudential” regulation could help to correct, critical market failures within the financial system. The article also shows why some of these markets failures cannot be completely corrected, and explores the consequences—both efficiency-related and systemic—of those inevitable failures. Thereafter, the article analyzes how “macroprudential” regulation could help to protect the financial system’s network functions.

Although macroprudential regulation would ideally work ex ante by eliminating the triggers of systemic shocks, the inevitable microprudential failures, coupled with structural vulnerabilities of the financial system that can trigger systemic shocks, make that impracticable. Certain of these vulnerabilities are almost universally common to finance because of their efficiency benefits. For example, maturity transformation—the asset-liability mismatch that results from the short-term funding of long-term projects—reduces funding costs, even though it increases the potential for defaults. Similarly, limited corporate liability encourages equity investment in firms but it can motivate risky corporate conduct. Other vulnerabilities are intrinsic to the very nature of the financial system.

Because regulation cannot eliminate all the triggers of systemic shocks, macroprudential regulation should also work ex post to protect the financial system’s network functions by mitigating the harm from systemic shocks that inevitably will occur. That involves breaking the transmission and limiting the impact of those shocks. Although some risk factors that influence the transmission and impact of systemic shocks are known, the transmission mechanisms cannot all be identified. Regulation therefore cannot completely break the transmission of systemic shocks.

Finally, the article explores ways to limit the impact of systemic shocks, effectively stabilizing the financial system when so impacted. This could be done in at least two ways: by requiring systemically important financial firms and markets to be more internally robust, and by providing appropriate liquidity to those firms and markets. Financial regulation has traditionally focused on the former—exemplified by laws requiring deposit-taking banks to be robust, usually through capital and solvency requirements. Since the financial crisis, the United States and other countries are beginning to also subject “systemically important” non-bank financial firms to these types of requirements.

Viewing macroprudential regulation from a functional perspective, however, reveals greater regulatory flexibility. Traditional financial regulation is inflexible because it implicitly, and confusingly, conflates microprudential and macroprudential regulatory goals. Firm-specific capital and solvency requirements are intended to protect the components of the financial system, and thus are microprudential. But traditional financial regulation imposes those requirements for macroprudential purposes also: if all systemically important firms are required to be robust, fewer should fail—and therefore the financial system should be less likely to fail.

That logic is true insofar as it goes, but it has two flaws. First, it is difficult to determine in advance which firms are systemically important. Because firm-specific capital and solvency requirements are not always economically efficient, imposing those requirements on all potentially systemically important firms is wasteful. Second, firm-specific requirements ignore financial markets, which increasingly are sources of systemic risk. A better macroprudential regulatory approach might be to provide liquidity to firms and markets if and when needed to protect the financial system’s network functions.

This article does not claim that its functional framework for analyzing and designing the regulation of a dynamically changing financial system can, or necessarily should, drive the enactment of actual law. The intention, rather, is to provide a set of regulatory ordering principles with which real-world financial regulation can be compared, whatever the existing financial architecture. Current regulatory approaches are often viewed, for example, as an assortment of “tools” in a regulatory “toolkit.” This article’s framework not only informs the use and limits of these tools but also reveals at what stages, and for what purposes, financial regulation more generally should operate. Additionally, the framework helps us decide between competing regulatory objectives and reduces the potential for regulatory arbitrage. The result should be a financial system that is more resilient than at present, with components that function more efficiently.

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