30 Pages Posted: 29 Apr 2012 Last revised: 28 Jun 2012
Date Written: March 28, 2012
Regulation that is designed to enhance the stability of individual financial institutions, micro-prudential regulation, can create and exacerbate systemic instability. This is particularly true of detailed prescriptive rules about corporate governance which are prone to incorrect specification and the imposition of unwarranted homogeneity on the conduct of firms. They can create externalities where none previously existed. Harmonization of micro-prudential regulation across countries elevates this problem to a global level of financial instability and can be a source of, rather than, a cure for global financial crises.
Regulation required to protect the financial system as a whole, macro-prudential regulation, is fundamentally different in nature from micro-prudential regulation. It seeks to identify, immunize, isolate and intervene in financial failures and, in contrast to micro-prudential regulation, it requires international harmonization across countries. The focus of harmonization to date has therefore been precisely the opposite of what is required to protect the financial system.
In a systemic context, capital is of fundamental significance and the tax system should be employed to encourage banks to hold appropriate levels of capital. The capital provisions of individual institutions should be supplemented by reserves of central banks, the amounts being dependent on the systemically important banks under the central banks’ authority. Bail-ins of convertible debt should be triggered by systemic not individual institutional failures. Costs of intervention and moral hazard should be minimized by writing down debt and equity in failing institutions, and equity but not debt in second round institutions threatened by first round failures. Harmonization of macro-prudential regulation should be overseen by a global committee of central banks which ensures the correct designations of banks, adequate holdings of central bank reserves, and coordinated interventions organized around lead central banks.
Keywords: Regulation, Harmonization, Systemic Risks
JEL Classification: G21, G28
Suggested Citation: Suggested Citation
Mayer, Colin and Gordon, Jeffrey N., The Micro, Macro and International Design of Financial Regulation (March 28, 2012). Columbia Law and Economics Working Paper No. 422. Available at SSRN: https://ssrn.com/abstract=2047436 or http://dx.doi.org/10.2139/ssrn.2047436