Since self-regulation, expected from ethics or the instinct for self-preservation, and market discipline has not worked, world opinion is veering around to stricter regulation for financial markets. But regulatory discretion also has adverse effects. It can restrain useful activity or support special interests if there is regulatory capture. The important question is not more, but appropriate, regulation. To understand what this is, we start from four basic market failures that justify regulation in financial markets. We show how neglecting these first principles contributed to market and regulatory failures. Next, we pull together regulatory reform proposals, and regulatory structure, that could best address these failings.
The four categories of failure are excess volatility and procyclicality, information failure, exclusion, market power and size. A combination of micro and macro prudential regulation can usefully moderate the failures. For example, insurance premiums for contributions to systematic risk through size could make large size less profitable. Regulation that induces better outcomes through creating correct incentives for market participants is the key. New technology has the potential to improve disclosure and make innovation safer.
Global coordination of basic prudential standards is also necessary. We demonstrate how such standards can push financial firms to choose safe over risky strategies, by removing the moral hazard from bailouts, and assuring that the competitor is not adopting risky strategies either. Universal application of basic standards prevents regulatory arbitrage. Global regulatory bodies may be more immune from financial lobbying to relax standards. A pure principles-based regulatory approach could be too flexible, but principle-based rules retain sufficient operational flexibility while reducing the delays and capture that come with regulatory discretion. The principles on the basis of which these rules are to be designed are the categories of market failure.
Stricter regulatory surveillance in emerging market economies (EMEs) largely insulated their financial systems from the crisis. Development and convergence of regulatory apparatus has been rapid. In some respects, EMEs may be closer to new global norms. The development of financial markets, however, is a major aim for regulation in EMEs along with financial stability. We examine the success in achieving these objectives in the Indian case. Some problems of regulatory overlap and coordination should be resolved keeping in mind the lessons of the crisis.
The paper is structured as follows: Section two presents the market failures that justify regulation; Section three the market and regulatory failures that led to the crisis; Section four the directions implied for regulatory reform; Section 5 for regulatory structure. Section 6 brings in issues that become relevant in EMEs where stable development of markets is a concern. Section 7 illustrates the analysis with the Indian experience before Section 8 concludes.
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