Financial regulation: Efficiency vs stability trade-off

Over at Rates Blog the trilogy of articles I’ve put up about the GFC has been completed with this one.  The first two artices are here and here, and the blog post I did on them are here and here.  Infometrics will be popping up some more articles on Tuesday’s, but they won’t be on the GFC anymore 😉

So in the first two I mentioned uncertainty about the lender of last resort function as a catalyst for the crisis, and a reason why it persisted.  However, this isn’t a costless function – it is true that introducing financial regulation to induce “stability” will impact on the efficiency of the financial markets.

We like to pretend this is not the case.  We like to pretend that the government has the knowledge and ability to figure out what the “externality” is and what “credit ratios” are appropriate – and so faced with a crisis we tend to focus solely on stability.

However, this is not the case.  In fact, the crisis occurred in part due to our determination to make the banking sector around the world more competitive – leading to the development of the shadow banking sector to avoid regulation.  In such a case, we can only get “appropriate” regulation when we in turn accept lower competitiveness in the banking sector.  And given the “supernormal profits” banks get in this case, they are ripe for second best style regulation through the central bank.

In truth, we either throw out the central bank and have competition over the medium of account through banks directly (allowing them to work together in the face of bank runs), or we have a central bank who directly regulates the whole businesses – it was our attempt to get the best of both worlds that helped us wander into the situation we found ourselves in.

Now none of this is news for central banks – they have been trying to length maturities for bank liabilities and clarify and improve regulation in the banking sector for some time.  The crisis was a reminder of the unintended consequences of regulation – firms (in this case banks) can innovate to avoid regulation as well, and that can be costly.  This must be taken into account, and the full cost involved should be accepted, when it comes to setting up policy – rather than throwing around piecemeal rushed ideas and concepts.