Highly leveraged institutions: Possible regulatory responses
| Pages | 209-218 |
| Published date | 01 March 1999 |
| Date | 01 March 1999 |
| DOI | https://doi.org/10.1108/eb025009 |
| Author | Jeremy Richardson |
| Subject Matter | Accounting & finance |
Journal of Financial Regulation and Compliance Volume 7 Number 3
Highly leveraged institutions: Possible
regulatory responses
Jeremy Richardson
Received: 2nd June, 1999
Financial Services Authority, 25 The North Colonnade, Canary Wharf, London, E14 5HS;
tel:
0171 676 3146; fax 0171 676 9729.
Jeremy Richardson works in Economics of
Financial Regulation, a small research
area in the Financial Services Authority
(FSA) which aims to cover such topics as
the rationale for regulation, the costs and
benefits of various aspects of regulation,
and the structure and development of the
financial services industry. Jeremy joined
the Bank of England in 1981 with degrees
in mathematics and economics, and
worked in various areas at the Bank,
including seven years in banking supervi-
sion, before transferring to the FSA in
1998.
ABSTRACT
The experience of Long-Term Capital Man-
agement (LTCM) demonstrated various ways
in which highly leveraged institutions (HLIs)1
can threaten the stability of financial markets.
This has sparked a policy debate about the pos-
sible
responses
by the authorities to
reduce
those
threats. This paper attempts to take a step back
from that policy debate. It summarises briefly
what economic theory says are
the
fundamental
reasons
for regulatory intervention in any form
of financial services business — essentially that
there is a market failure to correct. It assesses
the way in which HLIs may contribute to var-
ious of those types of market failure. And it
runs through the proposals which have so far
emerged for dealing with the weaknesses shown
up by
LTCM,
showing how each
corrects
for
the market failure in question, how big the ben-
efits delivered by that
correction
are, and ques-
tioning how far the
benefits
justify the costs of
implementing it.
ROLE OF REGULATION IN FINANCIAL
SERVICES
Before turning to the issues raised by HLIs
in particular, it is worth setting out briefly
the general principles underlying the regula-
tion of financial services.2 Economists gen-
erally start with the presumption that
competitive free markets normally achieve
the most efficient allocation of resources. To
justify official intervention in the operation
of markets, we need to be able to point to
ways in which those markets fail to deliver
the competitive outcome, and then deter-
mine if the intervention yields benefits
which outweigh its costs. There are two
broad categories of market failure which are
typically present in financial services, sys-
temic risk and asymmetries of information.
First, systemic risk: a well-functioning
market requires all participants to price all
the costs and benefits they impose on one
another. Certain types of financial services
firms (notably banks) are, however, cap-
able of imposing wider damage on the
economy if they fail. Left to themselves,
they will tend not to price this risk into
their behaviour and hence will take
excessive risk (they impose a negative
Journal of Financial Regulation
and Compliance, Vol. 7, No. 3,
1999.
pp 209-218
© Henry Stewart Publications.
1358-1988
Page 209
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