The new global financial regulatory order: can macroprudential regulation prevent another global financial disaster?

• Author: Gohari, Behzad

1. INTRODUCTION II. HISTORY OF PRUDENTIAL REGULATION A. The Predominance of Microprudential Regulation B. The Incomplete Structure of Microprudential Regulatory Systems III. THE EVOLUTION OF MACROPRUDENTIAL REGULATION A. An Overview of International Prudential Regulation 1. International Prudential Regulation Prior to 2008 2. Movement Towards Macroprudential Regulation After 2008 B. Prudential Regulation in the United States 1. Prudential Regulation Prior to 2008 2. Post-Crisis Prudential Regulation in the United States: Dodd-Frank IV. STRENGTHS AND WEAKNESSES OF MACROPRUDENTIAL REGULATORY SCHEMES A. Global Regulatory Harmonization: A Double Edged Sword B. Domestic Regulatory Coordination & Cooperation C. Evolving View of Risk D. The Future of Macroprudential Regulation in the United States E. Technology and Information Asymmetry V. CONCLUSION I. INTRODUCTION

   Carter Glass, author of the Glass-Steagall Act and Secretary of Treasury under President Wilson, once asked: "Is there any reason why the American people should be taxed to guarantee the debts of banks, any more than they should be taxed to guarantee the debts of other institutions, including merchants, the industries, and the mills of the country?" (1) What Glass could not have foretold were financial institutions so large and interconnected, so deeply integrated into every facet of the global economy, that the failure of one would trigger a crisis rivaled only by the Great Depression. It was in such an unfathomable socio-economic and regulatory environment, some 90 years later, on a late summer afternoon in 2008, when another Secretary of Treasury--Hank Paulson--fell to his knees in the bowels of the U.S. Congress and begged Nancy Pelosi for a $700 billion check with no strings attached to bail out the largest financial institutions in the United States by guaranteeing their debts. (2) That a champion of markets, free from and uninhibited by regulation, a man who only days before allowed a stalwart of American finance to file bankruptcy for fear of creating "moral hazard," felt compelled to kneel before one of the staunchest critics of deregulation, was a singular moment in the biggest, deepest financial crisis in the United States in over 70 years. (3)

   A month earlier, as the crisis was unfolding, Chairman Bernanke, in a speech before the Federal Reserve Bank of Kansas City, outlined the Federal Reserve's three-pronged approach to the crisis. The first two prongs were traditional central bank tools: the easing of monetary policy and offering "liquidity support" to the markets as needed. (4) The third component--macroprudential regulation--was a multifaceted approach to the crisis that advocated a stronger role for the Federal Reserve as a regulator. (5) Bernanke advocated for the expansion of the regulatory system's "field of vision," including macroprudential "oversight" in a step that would "broaden the mandate of regulators" and address systemic risks to manage the unfolding crisis and prevent future crises from having such a deep impact. (6)

   The financial crisis of 2008, like the pandemic Spanish flu 90 years prior, spanned the globe twice and caused substantial destruction. It also introduced an entirely new lexicon of economic and regulatory terminology, such as "contagion" and "systemic shock," into the popular and academic legal community; one such term is "macroprudential" regulation. (7) Once an obscure term used by a select few banking economists, it now forms the cornerstone of a vast global regulatory regime with advocates claiming that it will prevent future systemic shocks. (8)

   The purpose of this Article is to examine the roots of macroprudential regulation and its path to prominence as the next "messiah" of the financial markets. This Article presents an overview of the challenge in the implementation of macroprudential regulation as it has gone from a theoretical construct to a regulatory tool, its domestic and cross-border development, and applications in the United States. (9) This analysis is pertinent as it examines the strengths and weaknesses of macroprudential regulation as currently implemented, as well as the opportunities and threats macroprudential regulation faces, given that it is an economic theory being ported into a regulatory environment that is beset by social, political, and administrative roadblocks.

   Part II presents a brief history of prudential regulation and an overview of microprudential regulation and its incomplete regulatory scope. Part III examines the spectrum that contains both micro and macroprudential regulation, with the purpose of providing an adequate differentiation between the two areas and examining the rise of macroprudential regulation as the choice of regulators for the mitigation of systemic shocks. Part III presents the prudential regulatory efforts made on an international level, analyzing the efforts of various groups prior to and after the global financial crisis of 2008. (10) Part IV presents an analysis focusing on the strengths and weaknesses of macroprudential regulation. (11)

   This Article posits that the success of macroprudential regulation will depend on four factors. First, the economic philosophy of the central banker in charge of the domestic institution with jurisdiction over macroprudential regulation will prove crucial in the implementation of adopted regulation. If, like Chairman Greenspan, the banker is averse to the exercise of the Central Bank's regulatory oversight authority, then no amount or volume of policy or regulation will prevent or mitigate systemic risks and the accompanying shocks. (12) Second, a sufficiently deep level of international cooperation is required to mitigate regulatory arbitrage, without being so broad that the ensuing harmonization of regulatory regimes will result in a homogenized global regulatory system that will possibly give rise to a productization of risk and therefore a far more rapid spread of systemic risk and shock. (13) Third, the acceptance of macroprudential regulation by disparate domestic regulators will require a new guiding philosophy for the financial industry that will allow the macroprudential regulator the opportunity to meet its mandate and provide a foundation for system-wide success. Fourth, there needs to be a sufficient level of political willpower on the part of domestic legislatures and regulators in the face of what may be fierce opposition to macroprudential regulation by the largest and most politically powerful institutions the policy aims to supervise. (14) To counter this, macroprudential regulation is primarily under the purview of the Central Bank, and therefore less prone to regulatory or political turbulence. (15)

   To explore the present and possible future impact of macroprudential regulation, one must recognize the possible implications of the current regulatory proposals. One way to ascertain such information is to examine the strengths and weaknesses of macroprudential regulation as it is currently proposed and implemented. As such, this Article considers the possible opportunities and threats that lay ahead within a policy and regulatory framework that considers the economic, political, and international implications of macroprudential regulation proposals.

2. HISTORY OF PRUDENTIAL REGULATION

   1. The Predominance of Microprudential Regulation

      The banking and securities regulation regime in the united States has long been designed to regulate transactions and entities, not the entirety of the financial services industry. This regulatory structure is based on the long-held belief that a disclosure-based system--which requires the party in possession of information to disclose, or abstain from, trading--provides the strongest protection for investors, maintains market efficiency, and enables capital formation. This belief system runs deep, not just in the regulation of the securities markets but in the entirety of the financial services industry. (16) The logical extension of this system has been a regulatory environment shaped by microprudential regulation, and designed to manage prudential risk by focusing on individual institutions and assessing their systemic risk potentials in the context of regulatory oversight. (17)

      Microprudential regulation focuses primarily on regulating institutions and transactions, thereby managing risk using a "bottom-up" approach that centers on exogenous risk and aims to protect the consumer of the financial services--the investor and/or depositor. (18) This regulatory system takes the view that markets are "largely efficient" and simply require better and "more timely" disclosure to provide more transparency to the participants. (19) In this system, a regulator's role is to collect and disseminate information and to ensure that individual entities offering products and services in the financial services market are not denying the end user the information deemed necessary. As a result, the focus of this form of regulator becomes the availability and dissemination of information, the prevention of insider trading or market abuse, and the assurance that the market's operation continues unimpeded.

      The focus on microprudential regulation through concentration on institutional risk arose and was coupled with the deregulatory zeal that consumed the United States for almost three decades prior to the 2008 crisis. (20) The Financial Services Modernization Act of 1999, the Gramm-Leach-Bliley Act (GLBA), is one example of such deregulation. (21) Enacted with the belief that Glass-Steagall was no longer necessary, it contributed to the rise of an era in which financial behemoths would offer banking, brokerage, and trading services that, when combined with new and innovative products offered by the same firms and their proprietary trading departments, created risks heretofore unseen. (22) GLBA is also credited with inadvertently giving birth to "too big to fail"...