For Diversity in the International Regulation of Financial Institutions: Redesigning the Basel Architecture

Abstract

This paper challenges the prevailing view of the efficacy of harmonization of international financial regulation and provides a mechanism for facilitating regulatory diversity and experimentation within the existing global regulatory framework. the Basel accords. 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, as a means of reducing systemic risk, It proposes making the Basel architecture more adaptable by creating a procedural mechanism by which departures along multiple dimensions from Basel 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 departures from Basel, and upon approval, ongoing monitoring 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.