Securities Law Prof Blog

Editor: Eric C. Chaffee
Univ. of Toledo College of Law

Sunday, August 12, 2012

Romano on International Regulation of Financial Institutions

For Diversity in the International Regulation of Financial Institutions: Redesigning the Basel Architecture, by Roberta Romano, Yale Law School; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI), was recently posted on SSRN.  Here is the abstract:

This paper challenges the prevailing view of the efficacy of harmonization of international financial regulation and provides a mechanism for facilitating regulatory diversity within the Basel accords framework. Recent experience suggests that regulatory harmonization can increase, rather than decrease, systemic risk. By incentivizing financial institutions worldwide to follow broadly similar business strategies, regulatory error contributed to a global financial crisis. Furthermore, the fast-moving, dynamic nature of financial markets renders it improbable that regulators will be able to predict with confidence what optimal capital requirements or other regulatory policies are to reduce systemic risk, the objective of global harmonization efforts, nor what future financial innovations, activities or institutions might generate systemic risk. The paper contends, accordingly, that there would be value added from increasing the flexibility of the international financial regulatory architecture and advocates, as a means of implementing that goal, fostering regulatory diversity and experimentation within the existing Basel framework. It proposes making the Basel architecture more adaptable by creating a procedural mechanism by which departures along multiple dimensions from Basel’s strictures would be permitted while providing safeguards, given the limited knowledge that we do possess, against the ratchetting up of systemic risk from such departures. The core of the proposal is peer review of proposed deviations from Basel, and ongoing monitoring of departures, for their impact on global systemic risk. If a departure were found to increase systemic risk, it would be disallowed. Such a mechanism would improve the quality of regulatory decisionmaking by generating information on what regulation works best under what circumstances, and by providing a safety valve against a harmonized regulatory error’s increasing systemic risk, by reducing the likelihood that international banks worldwide will follow broadly similar flawed strategies in response to regulatory incentives

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