Unintended Consequences of Regulation
Featured Piece
“Market Failures and Regulatory Failures: Lessons from Past and Present Financial Crises,” by Professors Matthew Richardson, Viral Acharya, Thomas Cooley, Ingo Walter, in Financial Sector Regulation and Reforms in Emerging Markets by Masahiro Kawai, 2010. ABSTRACT
We analyze the financial crisis of 2007-2009 through the lens of market failures and regulatory failures. We present a case that there were four primary failures contributing to the crisis: excessive risk-taking in the financial sector due to mispriced government guarantees; regulatory focus on individual institution risk rather than systemic risk; opacity of positions in financial derivatives that produced externalities from individual firm failures; and runs on the unregulated banking sector that eventually threatened to bring down the entire financial sector. In emphasizing the role of regulatory failures, we provide a description of regulatory evolution in response to the panic of 1907 and the Great Depression, why the regulation put in place then was successful in addressing market failures, but how, over time, especially around the resolutions of Continental Illinois, Savings and Loans crisis and the Long-Term Capital Management, expectations of too-big-to-fail status got anchored. We propose specific reforms to address the four market and regulatory failures we identify, and we conclude with some lessons for emerging markets.
In the Media
“This time, ask the right questions,” by Professor Viral Acharya, The Financial Express, November 24, 2009.
“Regulation, Not Markets, Let Us Down," by Professor Viral Acharya, Causes of the Crisis (Blog), November 4, 2009.
“Why I-banks were fated to be roadkill,” by Professor Viral Acharya, The Financial Express, October 21, 2009.
Papers
ABSTRACT (Click Here for Paper)
Governments often have short-term horizons and are focused excessively on the level of current economic activity, disregarding whether financial-sector regulation designed to achieve it leads to long-term instability. Their short-term objective can be well served through policies governing competition and risk taking in the financial sector. By allowing excessive competition, providing downside guarantees, and encouraging risky lending for populist schemes, governments can create periods of intense economic activity fueled by credit booms. This way, governments effectively operate as “shadow banks” in the financial sector, a moral hazard that can have even more adverse consequences than risk-taking incentives of the financial sector. This government role appears to have been at the center of recent boom and bust cycles, especially in the housing sector in the United States through the presence of government-sponsored enterprises (Fannie Mae and Freddie Mac), and continues to pose a threat to financial stability.
Governments often have short-term horizons and are focused excessively on the level of current economic activity, disregarding whether financial-sector regulation designed to achieve it leads to long-term instability. Their short-term objective can be well served through policies governing competition and risk taking in the financial sector. By allowing excessive competition, providing downside guarantees, and encouraging risky lending for populist schemes, governments can create periods of intense economic activity fueled by credit booms. This way, governments effectively operate as “shadow banks” in the financial sector, a moral hazard that can have even more adverse consequences than risk-taking incentives of the financial sector. This government role appears to have been at the center of recent boom and bust cycles, especially in the housing sector in the United States through the presence of government-sponsored enterprises (Fannie Mae and Freddie Mac), and continues to pose a threat to financial stability.
ABSTRACT (Click Here for Paper)
We analyze the financial crisis of 2007-2009 through the lens of market failures and regulatory failures. We present a case that there were four primary failures contributing to the crisis: excessive risk-taking in the financial sector due to mispriced government guarantees; regulatory focus on individual institution risk rather than systemic risk; opacity of positions in financial derivatives that produced externalities from individual firm failures; and runs on the unregulated banking sector that eventually threatened to bring down the entire financial sector. In emphasizing the role of regulatory failures, we provide a description of regulatory evolution in response to the panic of 1907 and the Great Depression, why the regulation put in place then was successful in addressing market failures, but how, over time, especially around the resolutions of Continental Illinois, Savings and Loans crisis and the Long-Term Capital Management, expectations of too-big-to-fail status got anchored. We propose specific reforms to address the four market and regulatory failures we identify, and we conclude with some lessons for emerging markets.
We analyze the financial crisis of 2007-2009 through the lens of market failures and regulatory failures. We present a case that there were four primary failures contributing to the crisis: excessive risk-taking in the financial sector due to mispriced government guarantees; regulatory focus on individual institution risk rather than systemic risk; opacity of positions in financial derivatives that produced externalities from individual firm failures; and runs on the unregulated banking sector that eventually threatened to bring down the entire financial sector. In emphasizing the role of regulatory failures, we provide a description of regulatory evolution in response to the panic of 1907 and the Great Depression, why the regulation put in place then was successful in addressing market failures, but how, over time, especially around the resolutions of Continental Illinois, Savings and Loans crisis and the Long-Term Capital Management, expectations of too-big-to-fail status got anchored. We propose specific reforms to address the four market and regulatory failures we identify, and we conclude with some lessons for emerging markets.
ABSTRACT (Click Here for Paper)
The US financial services sector is heavily regulated. The regulatory structure is quite complicated, with a myriad of regulatory agencies and overlapping responsibilities. This structure is daunting and confusing, and it has its costs and complications. However, a great advantage to this complicated and duplicative system is that it gives someone with an innovative idea more than one place to turn; there is no monopoly regulator. Although there are periodic calls for simplifying the system, a major cost from simplification would be this reduced choice, and consequent reduced innovation.
The US financial services sector is heavily regulated. The regulatory structure is quite complicated, with a myriad of regulatory agencies and overlapping responsibilities. This structure is daunting and confusing, and it has its costs and complications. However, a great advantage to this complicated and duplicative system is that it gives someone with an innovative idea more than one place to turn; there is no monopoly regulator. Although there are periodic calls for simplifying the system, a major cost from simplification would be this reduced choice, and consequent reduced innovation.
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