A number of economists and financial experts have begun suggesting that discussions of regulatory reform—at the G-20 summit meeting in mid-November and elsewhere—should be curtailed or postponed because the implied tightening of regulation could complicate the management and recovery from the financial and economic crisis. I think this view is overwrought. Let me elaborate.
- Characterizing the whole set of regulatory reforms as implying a clamp-down on financial firms or a tightening of lending is misleading. Some proposed reforms—such as an increase in minimum risk-weighted capital requirements—certainly go in that direction. Others, such as the establishment of a central clearing party for over-the-counter (OTC) derivatives, or the passing of an orderly resolution framework for systemically-important nonbanks, are more likely to cushion the impact of the downturn by lowering default probabilities or lowering the cost of the failure of a large financial institution. And still other reforms—such as increasing transparency and disclosure requirements for complex structured products and selling them only to “sophisticated” investors—would have little cyclical relevance.
- There has been precious little implementation of any significant regulatory reforms to date. The relevant regulatory authorities have all indicated that they do not plan to implement any changes in the near term when the crisis is still raging. Indeed, where regulations have actually been changed recently, it has been mainly in the direction of forbearance—be it in the revised (read softer) guidelines for the interpretation of fair value accounting or in allowing Fannie and Freddie to lend beyond their regulatory capital requirements. I don’t share the view that the G-20 summit was sending a message that immediate steps need to be taken to keep the next boom from getting out of hand. Asking working groups and regulatory bodies to report back with specific recommendations in five months is not the same as implementing those reforms immediately. The point is that even if agreement on a regulatory agenda were agreed at the next G-20 meeting—and I think it’s a very big if—there is no logical reason why implementation of that agenda cannot be put off—at least for those items that have cyclical characteristics—until the recovery from this crisis is firmly established.
- The notion that we have to worry about rogue regulators who will implement reforms that run against the wishes of finance ministries, central banks, and G-20 leaders is far fetched. We now have the Financial Stability Forum, where regulators meet with their macro counterparts and presumably discuss what to do and what not to do. More fundamentally, it is the G-20 leaders and finance ministries that are instructing the regulators what to do—not vice versa. There is a reason why the regulatory literature emphasizes concerns about regulatory forbearance much more than it deals with regulatory vigilantes.
- It also does not make sense for officials to tell the public that they are looking at reform but won’t discuss any specifics until 2010, as some have suggested. Here you have the largest financial crisis in decades and the public is justifiably furious over how this was allowed to happen. In response, we should not ask the official sector is to say that because it’s impossible for us to walk and chew gum at the same time, we can only look at how to get out of this crisis—not how to prevent it from happening again.
- I also don’t buy the argument that because we are in the middle of the crisis and because so many fundamental things have changed, it’s not possible to see what the regulatory reform agenda should look like. After all, 16 months into the crisis, it ought to be possible to see what some of the leading problems were and how to fix them. That assumption is of course the basis for my ten reforms [pdf]. Also, why assume that we get only one bite of the apple? As new problems come up, new solutions or revised proposals will be forthcoming. From everything we know, the US Congress intends to study the regulatory reform issue over the next year, but you have to start from somewhere. I doubt that public confidence would be strengthened by having the official sector declare that this crisis is so unprecedented and so complex that we can’t even give you the outlines (now) of what we might need to do in the future to prevent a recurrence.
- Yes, announcements about possible future policy reforms can change behavior even before those reforms are implemented. But should we then have the official sector say that, after the crisis, we plan to propose reforms that will make it easier to increase the leverage of banks and other financial firms—so that we can spur lending right now? Obviously not.
- There is also the political economy of reform to take into consideration. If you wait until after the crisis is over to begin discussing the specifics of regulatory reform, you face the danger that the popular support for doing something significant will wane—especially as the financial industry’s lobbying groups get into action.
In sum, I think most everyone understands the point that implementing pro-cyclical reforms in the midst of a serious crisis would be a bad thing to do; for that reason, it is not likely to happen. I believe the critics are making a mountain out of a molehill by suggesting that even discussing plans for regulatory reform at G-20 summits and elsewhere has put the recovery in danger. There are plenty of serious things about crisis management to worry about; this is not one of them.