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The previous post, The Governance of Global Capital,makes the point that efforts to strengthen the Financial Stability Board (FSB) are needed to get the governance of global capital "right." The over-arching goal is to prevent another financial crisis that could undermine the international consensus on open, dynamic and liberal trade and payments.

The financial crisis revealed that, while financial markets are integrated on a global basis, supervision and prudential regulation largely remains national. Getting the governance arrangements "right" therefore requires balancing the need for stronger international regulation (and, I would argue, a better framework for the timely, orderly restructuring of sovereign debt) against the potential loss of sovereignty that this could entail.

National governments jealously guard sovereignty, of course, which preserves their discretion to act independently to promote and protect national interests. But the global financial crisis — like the Asian financial crisis before it — has demonstrated the negative spillover effects associated with regulatory and supervisory failures. National governments typically do not incorporate these potential external effects in making decisions about the design of regulatory frameworks or the treatment of distressed firms. As a result, regulatory frameworks for international capital markets are incomplete with the attendant risk of negative externalities.

Closing governance gaps requires a judicious balancing of national sovereignty against the potential risks of systemic crises.

At the same time, the crisis teaches that a more dynamic approach to regulation may be required.

Consider two broad possible approaches to regulation. The first is specific, ex ante regulation of activities: regulations governing what can or can't be done, capital, leverage and liquidity requirements, etc. Call this approach regulation by process. (There is a process for determining regulations, but once that is done, the task of the supervisor is to enforce these rules.) The second approach is regulation by judgment, under which public policy goals financial stability, say are identified and the regulator is given discretion (and authority) to make ad hoc adjustments to regulations in order to secure these objectives.

The distinction between the two approaches is, I think, hugely important in terms of the incentive structures that are established. Under a process approach, the regulator has done his job if all the boxes are checked off in terms of compliance with the guidelines. The danger is that institutions adhere to the letter of the regulatory framework but undermine the spirit by moving assets through off balance sheet conduits, etc. The example here is the growth of the shadow banking system prior to the financial crisis.

In contrast, a regulator with discretion is accountable for outcomes; not a process. If the goal of financial stability is compromised, she will be accountable for the failure. Put yourself in the shoes of the two supervisors and ask if you would be more ready to ask difficult questions, do meaningful stress tests and "what if" experiments under the two approaches.

To be effective, regulation must be dynamic, adjusting to changing behaviour and innovations that, in turn,  reflect the incentive structures created by the regulations themselves.

Here's the problem: While sovereign governments may be prepared to invest domestic regulators with the capacity to act based on their judgment, they will be loathe to delegate such powers to an international body such as the FSF. (Recall that Basel rules are formulated at the international level, but enforcement of them resides at the national level.) Governments may only be prepared to consider a judgment approach to international regulation if the scope of potential discretion is clearly identified and agreed to in advance. Moreover, the international body must be accountable for the exercise of its discretion — responsible for both "Type I" and "Type II" errors (responding to a problem that didn't exist, as well as failures to identify and prevent crises that do occur).

All of this sounds like an argument for constrained discretion. Indeed, it is. But there is a further problem when thinking of moving from the domestic to the international level. Sovereign governments that may be prepared to assign constrained discretion to domestic regulators would be unwilling to be bound by international bodies exercising discretion if the body lacks legitimacy. (In effect, the same point can be made with regard to the IMF.)

So, is constrained discretion the future of international financial regulation? Frankly, I'm not sure, but I do think that it is one way to balance the issues of national sovereignty and systemic risks.

The global financial crisis — like the Asian financial crisis — has demonstrated the negative spillover effects associated with regulatory and supervisory failures.
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