Roberta Romano

Yale Law School, NBER and ECGI

Pitfalls of Global Harmonization of Systemic Risk Regulation in a World of Financial Innovation

24/06/2020

The working hypothesis of international financial regulation is that it should be globally harmonized. This paper contends, to the contrary, that we should be wary about the efficacy of global harmonization, and in particular, harmonization of systemic risk measurement and regulation. The thesis is informed by what I consider two key lessons from the recent global financial crisis. The first lesson is that, when business strategies that internationally-harmonized regulation induces banks to follow go seriously awry, the adverse consequences will spread globally and not be limited to one regulator’s domain. The second lesson is that, innovations in financial technology that have been engines of prosperity across the globe also may contain the seeds of financial calamity with imprudent use and regulatory inattention. In addition, three kinds of uncertainty operate in this context: i) uncertainty regarding how best to define and measure systemic risk; (ii), dynamic uncertainty, that financial institutions respond to regulation in unpredictable ways that tend to undermine regulatory effectiveness; and (iii) radical uncertainty, that we do not know all possible future states of the financial system and therefore cannot compute the probabilities of outcomes that would be necessary for informing rules regarding systemic risk measures. The uncertainty in the regulatory context, in conjunction with the lessons from the crisis, suggest that a value-added international regulatory strategy would foster at least a modicum of diversity across national regulatory regimes, along with periodic updating of global standards. At the national level, they suggest adopting a dual-pronged regulatory approach that focuses regulators’ attention on monitoring developments in short-term debt markets, leverage levels, and the impact of new financial products and services, as well as on promoting experimentation, to better inform regulatory decisionmaking.

I. INTRODUCTION

The working hypothesis of international financial regulation, whether it be capital requirements or, as is the focus of this conference, systemic risk – “the risk that instability in the financial system will cause a recession or otherwise significantly impair the real economy”-- is that regulation should be globally harmonized. This chapter contends, to the contrary, that we should be wary about the efficacy of global harmonization, and in particular, harmonization of systemic risk measurement and regulation. The thesis is informed by what I consider two key lessons from the recent global financial crisis. The first lesson is that, when business strategies that internationally-harmonized regulation induces banks to follow go seriously awry, the adverse consequences will spread globally and not be limited to one regulator’s domain. In other words, harmonization can amplify, rather than dampen, systemic risk, which is particularly troubling when we are operating more or less in the dark.

 

The second lesson militating against harmonization of systemic risk regulation stems from the relation between crises and financial innovation. Innovations in financial technology that have been engines of prosperity across the globe also contain the seeds of financial calamity with imprudent use. This double-edged phenomenon poses an acute threat to regulatory efficacy. First, regulation that may have been effective when adopted can become counterproductive, if not toxic, as the economic environment changes, with, for example, the introduction of new financial products. Second, and relatedly, regulation must be attentively updated to retain its efficacy in light of the dynamism in financial markets, yet the necessary updating is exceedingly challenging to accomplish under the cumbersome process for revising the Basel Accords, which set the international standards for financial regulation, as it requires the agreement of numerous nations.

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