Implementing Better Banking Regulation and Other Standards: Lessons from the Past

Abstract

Diagnosis of the East Asian/Emerging Market crisis of 1997-1998 suggested that weaknesses in banking regulation and supervision may have contributed to the crisis. The arguments that were advanced for reforms to international banking regulation and supervision in that context may be of relevance in the present. Consideration of the past crises suggested that we are at a point of diminishing returns on additional expenditure of efforts on devising better standards and rules. The difficulties lie in administering the existing rules effectively. Further, the paper argues that improved disclosure and greater transparency do not necessarily eliminate surprises or reduce volatility, since markets adjust to the amount and quality of information in a system and operate on the edge of ignorance, which is the obverse side of the coin of fully discounting all known information. Moreover, information is feedback, which sometimes can be “positive” in nature, meaning it intensifies the event. Accordingly, increased information, being simply intensified feedback, can as easily imply more intense volatility if positive feedback loops exist. In the same vein, increased reliance on capital markets which depend on common information and less reliance on banks which run on private information risks leading to greater correlation of investor reactions and thus to sharper swings and greater short-term volatility. Generally speaking, changing the rules of the game from one crisis episode to another tends to invalidate the experience of the previous episode as a guide to the future. Finally, insofar as non-neutrality towards sources of risk is built into rules, this shifts the locus of risk – for example, tighter regulation of financial institutions shifts the action to unregulated markets; this does not eliminate risk in the economy or to the banks, it just alters the way in which banks wind up being exposed to risk. Avoiding risk in one area thus may mean backing into risk elsewhere – a financial market "relativity effect" that almost by definition generates surprises in each new crisis. The bottom line is that risk is real and ultimately cannot be avoided. This raises the question: Does improved regulation of banks add up to a "paradox of risk" that parallels the famous "paradox of thrift"?

(a) individual risk-taking by financial institutions and markets = stronger growth and more stable clients = lower collective risk;

(b) individual risk aversion by financial institutions and markets = slower growth less stable clients = greater collective risk.

Keywords: bank, regulation, supervision, financial crisis, volatility, risk

JEL Classification: G18, G28, G38