"Six principles for regulatory order"

After a modest interval with no big financial shocks, policy attention is turning to the task of preventing future crises and managing those that occur. While the deliberations will take quite a while to play out, there is some time pressure – because of the moral hazards created by the Federal Reserve’s extension of credit to investment banks and authorities’ desire to act before the sense of alarm created by recent events abates and complacency returns.

Proposals for changes in regulation and crisis response have come from many quarters, including the US Treasury and private sector groups. They offer important ideas on rearranging regulatory responsibilities – such as the Treasury’s suggestion of an enhanced role for the Federal Reserve with respect to investment banks and its call for a consumer financial regulator – and raise critical issues, such as that of procyclicality induced by regulation. They also contain a certain amount of essentially content-free calls for worthiness. So far missing from the debate has been a set of principles describing the properties of any desirable regulatory regime, against which proposals can be evaluated. Different observers will assign priority to different issues – here would be my list of six principles.

First, there should be a strong presumption against having regulators competing to supervise particular institutions or activities. Experience suggests that even when firms do not have the option of switching, there are substantial risks that regulators will be co-opted. Adding “forum shopping” exacerbates the problem.

Second, it should be recognised that to a substantial extent self-regulation is deregulation. Allowing institutions to determine capital levels based on risk models of their own design is tantamount to letting them set their own capital levels. We have seen institutions hurt again and again by events to which their models implied probabilities of less than one in a million. Where it is desired to impose capital requirements, this should be done in a way that can be monitored by supervisors on the basis of balance sheet data.

Third, regulation must be premised on the inability of institutions or their regulators to predict future market conditions with much confidence. As obvious as the subprime crisis may look in retrospect, it was not widely foreseen 18 months ago even by those worried about complacency in credit markets. As the fact that the Dow Jones index was below 6,500 when Alan Greenspan famously spoke of irrational exuberance illustrates, it is also easy to see bubbles even when assets are undervalued or properly valued, as