April 22, 2009
A New Paradigm for Financial Regulation
President Obama spoke of the mess in financial regulation and the need to clean up in his State of Union Address. With the banks and financial institutions and financial markets braving new odds everyday, of one thing there is consensus. Existing regulatory setup has not delivered and is passé. The regime of free market regulation characterized by the triad of supervision, audit and self regulation has come into question. It’s a sign of times that people are fighting shy of the most pervasive financial regulatory regime namely BASEL II International Standards for Capital Measurement and Capital Standards. There is, thus , a churning about the best way to regulate the markets. Against this background I would like to outline, according to my views, what the new regulatory regime should not be and more importantly what it should not be.
What should not be done?
When times are bad like now, it is easy for the pendulum to swing to the other extreme. Already shrill voices are being heard to put in place a comprehensive regulatory regime in which every micro aspect is controlled and directed by the statutory authorities. No doubt the current framework hasn’t had the strength to weather the storm, has wobbled under the stress but we need to guard against overdoing the regulation and establish micro level controls regime. Therefore the first danger to be avoided is the micro management of financial markets and players and instruments. Why? Don’t kill the market, the hen the lays the golden eggs. History has evidence that markets need to flourish and they do so through innovation.
Don’t throw away the quants. It’s only recently that quantitative measurement had emerged as the basis for market operations and market regulation. During a crisis like this, it is easy to malign the quants approach. We need to remember two things in this context : Financial markets are risk intermediation markets, their value lies in the way they facilitate the transformation, slicing and dicing of risks to cater to the varying profiles and appetites of the individual households, corporate and governments for raising resources and their optimal deployment. Its pretty obvious that this task is tough, complex and highly nuanced.
Secondly, risks are about the future uncertainty and there is no alternative to looking at the past data and making an attempt to abstract the patterns which could be recursive. While the total reliance on number crunching and their results as precise prognosis is certainly not correct, lets recognize that the quantitative estimates is all that we have. Numbers are not God, their patterns are not inviolable, but their the only peephole into the future. Lets improve the methods of analysis in modeling techniques and our estimations of various market events in the light of the experience of the current crisis but lets not castigate or abandon the work done over the years to provide an operational basis based on data and mathematical modeling. The rigor may not be irrefutable, but at least it can be used with good effect when we don’t regard it as the gospel.
Avoid the compliance mania : It is fashionable now to talk about compliance and corporate governance and ethics. They are no doubt important but they are not to be deified. They are all means for a purpose. The goal is growth and development through the medium of the financial markets invoking some vague ideas and establishing elaborate regimes for their implementation is counterproductive. Let’s not forget that the Enron corporation had been recognized for the best corporate governance standards. More recently in India, the Satyam Infotech had won the best corporate governance award successively for two years and ironically the peacock award had been conferred on it just a few months before the corporate fraud exploded.
We all like certainty in good behavior on the part of the corporate but it’s neither easy to command it nor useful to expect it. Of necessity, we need to have certain tentativeness about the corporate controls and the compliance requirements that we impose so that we can adapt them to the emerging scenarios as we move along.
Keep it simple and enforce with rigor.
Like in life, regulation needs to be clear, simple and unambiguous. Regulators have a knack of making things complex and confusing in an attempt to be comprehensive and correct. The regulatory arrogance must give way to conscious attempt to keep the regulation to the minimum and a continuous process to simplify it. I would suggest an annual review of all regulations and their relevance with a view to achieving targeted reductions a la the paper reduction requirements in the United States. The objectors will screen that it is not doable and involves very high costs. My answer to them is that the costs of the alternative of perpetuating confused and confusing regulatory matrix are several times more.
Given the natural tendency of a regulator to expand his turf and his power, there should be a rigorous regime to regulate the regulator and enforce inescapable discipline in the matter of regulation.
Make the regulation goal- oriented.
The goal of regulation has been and should be to support effective functioning of the markets. While this is a truism, somehow this tends to be missed often. In response to the changes in the financial markets from time to time, every country establishes statutory and other regulations to meet the specific demand of the market. However we forget to weed out the rules and regulations that have outlived their utility. The rescinding on existing control particularly in a democratic setup seldom happens unless there is a crisis as the vested interests develop in its perpetuation and the policy makers find it a safe option to do nothing. Our attempt should be to keep the regulation current and relevant through continuous review.
In summary, the new regulatory order should be simple, market -oriented and dynamic rather than elaborate, rigid and etched in stone. That is my view ! I would welcome your considered responses!
Posted by sssatchidananda at 09:05 AM
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