The Goldilocks Approach: Financial Risk and Staged Regulation

Abstract

Financial firms engage in a wide range of private conduct. New rules that address financial risk can regulate elements of that conduct but not all conduct or all the factors that affect conduct. There is, therefore, a real concern that new regulation will have unanticipated consequences, particularly in a system as complex as the financial markets. The result may be new risks or a shift in risk taking away from regulated conduct — responses that regulators can anticipate but may not be able to accurately predict or control.

This Article cautions against the rush to adopt new financial risk regulation without first assessing its broader impact on risk taking. Attempting to do so with limited information may be difficult. For illustration, it touches on three areas where new regulation may result in new (or greater) risks: bank capital requirements, a financial transaction tax, and disclosure in the credit default swap market.

A better approach may be to introduce new regulation in stages — what I refer to as the “Goldilocks approach.” Increasingly, regulators should be authorized to phase in or forego new regulation over time as it becomes clear, through experience, what the likely impact will be. At its heart, the Goldilocks approach relies on real options to develop new rules. Through staging, regulators can acquire additional information on the impact of new rules on conduct and, as necessary, adjust those rules to reflect any unanticipated consequences — perhaps a more effective approach to implementing regulation than efforts to finalize new rules from the outset.

Keywords: financial crisis, financial regulation, financial, staging, sunset, bank capital, financial transaction tax, credit default swap

JEL Classification: K20, K22, K23, K29, G18, G28, G38, D73, D83