The Core Challenges of Financial Regulation
| Author | Edward Price |
| Date | 01 September 2018 |
| Published date | 01 September 2018 |
| DOI | http://doi.org/10.1111/1758-5899.12569 |
The Core Challenges of Financial Regulation
Edward Price
London School of Economics’Civil Service, Government & Public Policy Alumni Group
Abstract
Financial regulation is characterised by policy challenges. These illustrate both specific challenges facing policy makers after
the global financial crisis and the general uncertainty involved in the design and implementation of coherent economic
policy.
The existence of economic policy is an acknowledgement
that the market mechanism can act as both a source of, and
a risk to, growth. As such, policy attempts to maximise risk-
adjusted growth i.e. harness the upside of market forces
and counteract the down. This balancing act leads to certain
policy challenges, some of which are very well-illustrated by
financial regulation.
The net effect of financial regulation
Our first challenge is the unknown. Economic policy makers
have no way of knowing the outcomes of those actions
they did not take.
As above, the ultimate mandate of all economic policy is
to support economic growth. In this context, financial regu-
latory reform efforts since the global financial crisis (GFC)
have been designed to avoid future GDP losses by avoiding
or mitigating the future financial crises that would again
cause such losses. Some commentators, however, argue that
post-crisis financial regulation will ultimately weaken eco-
nomic performance. This argument is intuitive. The core
thrust of financial regulation since the global financial crisis
has been to influence the level of bank credit by regulating
its demand (with loan caps) and supply (with either
enhanced or new rules for capital, liquidity and leverage). If
this agenda has meant that banks cannot lend as much to
the real economy, the real economy will likely not produce
the level of goods and services it otherwise might have
done.
This is the net effect of financial regulation, or the sum
total of the two contrary effects of regulation. One effect is
the avoidance or mitigation of financial crises, which should
result in avoiding losses to GDP. The other effect is the loss
of economic activity that comes with a more regulation-
restrained financial sector: this by contrast does lead to lost
GDP. The essence of the net effect of regulation, therefore,
lies in a counterfactual. We do not know in one (strict) regu-
latory scenario the GDP performance that may have resulted
from another (less strict) regulatory scenario. This sort of
known unknown is ripe for debate and illustrates why finan-
cial regulation per se is a challenge.
Regulating banks
The next core challenge is how to encourage, without over-
encouraging, the benefits of market forces.
Governments sometimes encourage banks, explicitly or
otherwise, to pick particular destinations for credit. These
nudges are known as credit allocation schemes, and the US
government, for example, signalled its support for a deeper
and wider pool of domestic residential mortgage credit
before the 2007-8 financial crisis. The resultant (repeat) les-
son was that an over-extension of credit can cause systemic
build ups of credit risk, financial crises and, ultimately, a
downward deviation from the long-run rate of growth. After
the crisis, policy makers have since acted to address future
bank lending, as per the above.
This is tricky. Were banks wholly restrained in their lend-
ing, they would certainly present a zero source of risk to the
financial system. Banks would, however, also cease to exist.
The question then becomes how to restrain bank lending
(and its risks to growth), without abolishing banks (and their
positive contribution to the same). Lord King, former Gover-
nor of the Bank of England, has offered the best work on
this issue with his Pawn Broker for All Seasons (PBFAS) pro-
posal.PBFAS would set limits on banks’lending long and
borrowing short based on banks collateral with the central
bank and would avoid the abolition of the (economically
valuable) maturity transformation function of banks, which
some risk-averse regulatory schemes have sometimes pro-
posed. Meanwhile, however, the issue remains live: how can
policy makers encourage the benefits of private sector credit
allocation without encouraging that mechanism to go too
far?
The distribution of systemic risk
Next, unintended consequences. These are a perennial prob-
lem in economic policy and regulation. On occasion, policy
can even result in the exact opposite of its stated aims.
By making one part of the financial system safer, namely,
banks, some argue that post-crisis financial regulation has
not made the overall system safer. If so, this was far from
©2018 University of Durham and John Wiley & Sons, Ltd. Global Policy (2018) 9:3 doi: 10.1111/1758-5899.12569
Global Policy Volume 9 . Issue 3 . September 2018
432
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