Is light-touch regulation passé?

Lucia Dalla Pellegrina, Donato Masciandaro, 17 November 2011

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During the Great Moderation stable growth was associated with a high level of certainty with regard to the general framework in which economic agents were operating, both cyclically and structurally. At the structural level, an important role was given to improving market regulation, which was itself part of a more effective system of public governance (Kaufmann et al 2002). The regulation paradigm was clear: the more market-friendly – ie, the more light-touch – the better. Regulation should foster an environment that makes individual risk-taking easier, by contributing directly to the efficient allocation of resources at the microeconomic level which, in turn, leads to steady growth at the aggregate level. The relationship between stable growth and well-designed rules was supported by theory and by empirical research (see, for example, Acemoglu et al 2005, Barth et al 2004 and Levine 2005a).

How the crisis called light-touch regulation into question

The crisis shattered this prevailing framework, to the extent that light-touch regulation – designed in order to optimise individual risk-taking – can be seen to have produced a negative externality by creating greater systemic risk and, therefore, a cost in terms of the volatility of growth itself. If there were robust clues to the existence of a correlation between light-touch regulation and the fall in growth, we could infer that such regulation does not automatically warrant optimal risk-taking, at least from a systemic point of view, as it had previously been assumed until 2007.

The issue of country vulnerability to the crisis has only recently entered the arena of economic analysis and has been conducted, until now, at a purely empirical level. A number of cross-section studies covering a large number of economies (see Dalla Pellegrina and Masciandaro forthcoming) reveal that regulation appears to be robustly associated with resilience. But this result is rather surprising, given that light-touch regulation appears to be inversely correlated with resilience.

Relevant research

Within the domain of regulation indexes, a number of market-friendly industry regulations have been previously considered (for example, see Giannone et al 2010). Among them, banking regulation emerges as particularly significant and appears to be inversely correlated to resilience. The more light-touch the banking rules are, the higher appears to be the vulnerability. We might label this phenomenon the ‘unpleasant nexus’, as it compels us to reconsider the paradigm that has guided theory and practice over the last two decades. The same result is confirmed by Rose and Spiegel (2010) and to an extent by Caprio et al (2010). It appears that instability was less likely where the structural constraints on banking activities were most binding and where the degree of transparency (private monitoring) of regulation was highest.

Masciandaro et al (forthcoming) find a direct correlation between light-touch regulation and instability, and enlarge the analysis to include banking supervision. The relevant aspects they consider for financial and banking supervision are:

(1)   the architecture of banking oversight;

(2)   the role of the central bank; and

(3)   supervisory governance.

They find that instability is greater relative to the degree of supervision and the quality of governance.

In summary, it would appear that the key hypothesis highlighted by the current literature is that light-touch banking regulation has provoked excessive growth in systemic risk and resulted in higher instability. Where the market-friendly approach has been tempered – either by direct constraints or through higher transparency – negative effects have been lessened.

Such an hypothesis should be valid only for the present crisis, in so far that in earlier episodes of instability the estimated effect was the opposite; stronger direct constraints heightened a country’s probability of entering a full-blown banking crisis (Barth et al 2004).

The ‘unpleasant nexus’ – an economic explanation

The link between the economic crisis and light-touch banking regulation can be described as a relationship in which the design of rules for banking activities has created widespread and positive incentives for individual risk-taking; the aggregate and unforeseen effect has been an excess of systemic risk, whose corresponding economic cost is represented by the consequent fall in GDP.

The question this gives rise to is whether the widespread and systematic increase in risk-taking depends only on the form of banking regulation.

The answer is clearly no. An economic agent takes on risk more easily if she operates within an institutional context of global light-touch regulation, of which banking regulation is just a part. Institutions impinge upon individual risk-taking by influencing the aggregate characteristics of financial and banking structures. We recently highlighted how the unpleasant nexus does not operate in a vacuum (Dalla Pellegrina and Masciandaro 2011). The link between vulnerability and light-touch banking regulation seems to signal a more general relationship between institutional design and macroeconomic performance. The analysis has shown how various types of institutions – public, political, legal, monetary – also seem to exert an unexpected effect on vulnerability. The quality of institutions – as measured in terms of them being effective tools to provide incentives for risk-taking choices aimed at creating economic value – seems to increase vulnerability.

What are the policy implications?

  • The crisis is an all-too-recent and complex phenomenon for a complete analysis at this time. Vulnerability – as measured by the drop in production and income that many countries, although not all, have experienced, and with differences in intensity – can either be a relevant but isolated episode or the start of a period characterised by higher volatility. What we can observe today is that such volatility is associated in a robust and systematic way with light-touch banking regulation.
  • We call this association ‘the unpleasant nexus’, in the sense that it calls into question the effects of a set of rules whose efficacy, in terms of being an engine for stable growth, seemed well-established.
  • If the unpleasant nexus is shown to hold in time, we should reconsider the cost-benefit analysis linked to such an approach. We might also question which and how many aspects of that approach need to be reformed in order to establish better guarantees, in terms of both growth and resilience.
  • The nexus seems to signal a more general relationship between institutional design and macroeconomic performance. The quality of institutions – as measured in terms of them being effective tools to provide incentives for risk-taking choices aimed at creating economic value – seems to increase vulnerability.

Conclusion

Until now, the aggregate outcome of stable growth was considered to be the consequence of a system of rules that created a favourable environment for individual risk-taking. The crisis has shown that the development of such institutions does not automatically result in the reduction of systemic risk to acceptable levels. Analogously to what we have concluded with regard to banking regulation, it will be interesting to continue to study the macroeconomic effects of institutions in order to assess their effective relevance, as well as the direction of possible reforms.

References

Acemoglu D, S Johnson and JA Robinson (2005), “Institutions as a Fundamental Cause of Long Run Growth”, in Aghion, Philippe and S Durlauf (eds), Handbook of Economic Growth, vol.1.

Barth JR, G Caprio and R Levine (2004), “Bank Regulation and Supervision: What Works Best?”, Journal of Financial Intermediation 13.2: 205–248.

Caprio G, V D’Apice, G Ferri and GW Puopolo (2010), “Macro Financial Determinants of the Great Financial Crisis: Implications for Financial Regulation”, ISTEIN WP Series 12.

Dalla Pellegrina, L and D Masciandaro (forthcoming), “Good Bye Light Touch? Macroeconomic Resilience, Banking Regulation and Institutions”, SSRN Working Paper Series, Paolo Baffi Centre, Bocconi University.

Davis and Kahn (2008), “Interpreting the Great Moderation: Changes in the Volatility of Economic Activity at the Macro and Micro Levels”, Journal of Economic Perspectives 22.4: 155–180.

Giannone D, M Lenza and L Reichlin (2010), “Market Freedom and the Global Recession”, CEPR Discussion Paper 7884, June.

Kaufmann D, A Kraay and P Zoido-Lobaton (2002), “Governance Matters II”, World Bank Policy Research WP Series, n. 2772 .

Levine R (2005), “Finance and Growth”, in Aghion, Philippe and S Durlauf (eds), Handbook of Economic Growth, vol.1.

Masciandaro, D, RV Pansini and M Quintyn (forthcoming), “Economic Crisis: Did Financial Supervision Matter?”, IMF Working Paper Series.

Rose AK and MM Spiegel (2010), “Cross-Country Causes and Consequences of the Crisis: An Update”, NBER Working Paper Series, n. 16243. 

Topics: Macroeconomic policy
Tags: global crisis, light-touch regulation, regulation

Lucia Dalla Pellegrina
Assistant Professor, University of Milan-Bicocca
Donato Masciandaro
Professor of Economics, and Chair in Economics of Financial Regulation, Bocconi University