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Banking and finance June 26, 2017

Managing the next financial crisis: against reflex-driven regulation

Money
Public confidence in the financial system has been severely damaged since the 2008 financial crisis swept in full force across the globe, bringing with it massive consequences for banks and taxpayers.

Government intervention prevented more serious consequences and averted a core meltdown of the financial system. Since then, general acceptance of market economies has undergone an enormous stress test, and it will take a while to restore lost faith.

As a consequence of what happened in 2008, it was clear that policymakers and regulators had to react. To avoid future risks, they must continue to take the steps necessary to make the financial system more resilient and shield states and taxpayers from having to pick up the bill when the banking sector gets into trouble, in particular by further increasing capital and liquidity standards for banks. At the same time, bankers feel increasingly strangulated by regulation, sometimes comparing it to a tsunami.

While this picture might be too much of a stretch, we cannot ignore the impression that some regulation is a hasty reaction. Once a problem is identified, there seems to be a legal imperative to address this problem, without evidence as to whether this legal response actually helps to alleviate the problem or simply placates the public.

The benefits of regulatory changes, their costs – such as the rapidly growing bureaucratic burden on information and reporting requirements – and the possible interactions between different regulatory steps have to be taken into account. The focus has often been on individual measures and sectors, where consistency and a holistic approach are needed.

What needs to be done?

Large-scale and credible studies on the costs and benefits of current regulatory steps are important because they intensively examine the taken measures in term of their impacts. In this context, the Financial Stability Board (FSB) recently published a Proposed Framework for Post‐Implementation Evaluation of the Effects of the G20 Financial Regulatory Reforms. The FSB is trying to evaluate the successes and failures of regulatory reforms on policy outcomes, thus developing an evidence-based policy design. For the FSB framework to be successful, it should consist of five pillars:

  • Political support implies that governments and bureaucrats are convinced that solid evidence is a necessary foundation for good policy design, thus taking the evidence seriously and translating it into policy. In this respect, the FSB framework is maybe most important. An approval by the heads of states and governments in the G20 meeting in Hamburg in July 2017 would ensure a high visibility and a strong signal of political commitment. 
  • Institutional capacity entails that the required resources have to be devoted to this endeavor. This is a necessary consequence of providing political support and should play a major role in the steps to come in the context of the FSB. More specifically, existing efforts for a more structured approach should be strengthened by requiring central banks, financial supervision authorities, and national ministries in charge of financial stability aspects to create entities specifically focused on evidence‐based policy evaluation.
  • Data access: For building a body of evidence, it is necessary to collect representative and comparable high‐quality data that can be accessed and evaluated by policy makers and researchers. This holds particularly true for central banks, which collect highly granular data on, for example, corporate and retail lending as well as risks in the financial system. A better and more comprehensive exchange of data across central banks and across G20 countries could thus enable better comparability and coordination among analysts and, as a consequence, better evidence‐based policy design.
  • Collaboration between researchers and policymakers: The latter have policy questions and contextual knowledge and the former have the analytic tools needed to build evidence. Collaboration between these two parties is therefore essential in the FSB framework process. One concrete step would be to invite researchers to become non‐resident fellows in the public entities to be created under point 2. Likewise, economic think tanks and research institutes could be asked to conduct these analyses on behalf of these entities.
  • Openness: Transparency as well as independence in monitoring and evaluation is integral to the process of creating a better policy design. Furthermore, public and easy access to the results of the evaluation process should be guaranteed, for example in the form of repository studies. (Rajshri Jayaraman and Jörg Rocholl, “Consultation process for G20 Financial Regulatory Reforms.” May 11, 2017).

The described process of the FSB framework is of high importance as it makes the costs and benefits of the regulatory reforms more transparent and visible, thus helping to better manage risks and improve the framework in general.

In order to reduce the odds of another financial crisis, we should protect capitalism not only from the capitalists, as a popular book title says, but also from reflex-driven regulation. The implementation of methodically credible and comprehensive impact studies would not be a retreat; rather it provides important and meaningful time to define the right next steps. Their results would help the discussion and root it in generally accepted facts. And it is vital that the next stages of regulation are based on facts rather than assumptions.

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