The Search for a New Regulatory Paradigm - Michael Taylor

• Citation: Vol. 49 No. 3
• Publication year: 1998

The Search for a New Regulatory Paradigmby Michael Taylor^*

The regulation of financial services in developed economies has not kept pace with the enormous changes that the industry has experienced over the last two decades. Despite the rapid integration of financial services across a number of different boundaries—geographical, functional, and sectoral—regulation remains rooted in a set of assumptions dating back to the 1930s. I term these assumptions and their associated institutional and legislative embodiment a "regulatory paradigm." In this Article, I argue that the traditional regulatory paradigm has become outmoded as the result of recent industrial developments and that this necessitates the creation of a new regulatory paradigm. This would include, as a minimum, new public policy objectives for regulation, a reassessment of the scope of regulation, new techniques of regulation, and new institutional and legislative structures of regulation. Although the precise form of this new paradigm is still to emerge, there are already a number of indicators of its likely shape, and these predominantly involve reliance on the market rather than public agencies as a key regulatory device.

In this Article, I begin by considering the traditional regulatory paradigm and the way in which it has been superseded by market developments. Second, I consider some of the possible alternative regulatory approaches currently being mooted. I also reflect on how the organizational structure of regulation needs to be modernized to reflect the changed environment of financial services. My intention is to try to connect these various points to the outline of the new regulatory paradigm. Nonetheless, the focus of this Article is deliberately narrow: I consider these issues only as they apply to banks and only to the extent that they concern prudential regulation. Many of the points I make apply equally to the securities houses and even some insurance companies, and there is also another equally as long article to be written about regulation of the sale of retail investments.

I. The Concept of a Regulatory Paradigm

The regulation of financial services depends on a set of shared models, practices, rules, and standards that might collectively be termed a paradigm.¹ This paradigm includes both the techniques of regulation and the environment in which they are embodied, including the institutional arrangements and certain basic assumptions about the objectives of regulation and about the nature of the industry being regulated. In the sense in which I wish to use the term, a "regulatory paradigm" can therefore be thought of as involving a combination of three major elements:

• The first element comprises the public policy objectives set for the regulatory system, including certain basic assumptions about the tradeoff between efficiency and stability and the extent to which government could or should seek to indemnify consumers against risk. These objectives are also informed by a number of theories concerning the nature of the regulated industry and the consequences of an unregulated environment.

• The second element concerns the institutional arrangements that are established for administering the set of regulatory requirements flowing from the public policy objectives. These include, for example, the manner in which regulation is organized, the basis on which agencies are structured, and the type and nature of the powers that are conferred on them.

• The third element includes the specific techniques and methods used by regulators for discharging the regulatory task. This third element comprises a wide range of issues, including the type and nature of the information that regulators gather from regulated firms, the standards they apply and the methods they use to ensure compliance with those standards, and matters like the kinds of knowledge and expertise regulatory personnel must possess.²

The traditional regulatory paradigm can be outlined by considering each of these elements.

First, with regard to the public policy objectives, the traditional paradigm (at least as it concerned banking) emphasized stability rather than competition. In the United States, for example, the traditional paradigm of banking regulation had its roots in the New Deal legislation of the 1930s, which in turn reflected a policy consensus that "competition as practiced had failed, and that government needed to assume greater responsibility for economic performance."³ Thus, the New Deal legislation was "designed to correct the perceived failings of competition, gave unprecedented authority to the federal government, and tried to solve problems for which existing economic theory had no effective answers, at least before Keynes."⁴

In the banking field, the emphasis of the New Deal legislation was on stability at the expense of competition. Taken collectively, legislation like the Federal Home Loan Bank Act of 1932, the Banking Acts of 1933 and 1935, the Securities Act of 1933, the Securities Exchange Act of 1934, the Federal Credit Union Act of 1934, the Maloney Act of 1938, and the Investment Company Act of 1940 "restructured the financial system, established a maze of new operating standards, segmented asset and liability markets by type and territory, fixed prices, and guaranteed risk. Stability was the overriding legislative objective; noncompetitive and inefficient markets were the result."⁵ The emphasis on eliminating risk and ensuring banking stability was discharged to a very high degree in the succeeding decades. Between 1934 and 1978, fewer banks failed in the United States than during any one year of the 1920s. This produced an amazing degree of industry stability over a forty-year period with the result that a time traveller arriving in the late 1970s from 1935 would have easily recognized the different types of financial institutions, most of their products, and their principal activities. This degree of stability was not only a product of the traditional regulatory paradigm but permitted its leading regulatory techniques to be practiced with a significant degree of success.

The institutional arrangements that flowed from these over-arching public policy objectives were also founded on clear segmentation of markets and products between debt, equity, and insurance contracts. Regulation of the financial services industry was conducted on largely sectoral lines with different agencies being charged with regulating each sector (and sometimes, as in the United States, with more than one regulator regulating each sector). Traditionally, banking regulation was the preserve of the central bank or of a banking commission with particularly close links to the central bank. Securities and insurance regulation also had their own dedicated agency or agencies. Moreover, these different sectoral regulators had correspondingly different philosophies of supervision. For instance, banking regulators were traditionally loath to see their institutions fail, whereas securities regulators traditionally regarded the failure of a regulated firm with greater insouciance, aiming primarily to achieve only an orderly wind-down of the company. Finally, an especially important point is that the regulation of financial services was almost entirely a domestic matter. One consequence of the restrictive regime imposed on banks in the period between 1930 and 1980 was that comparatively little business was cross-border. This meant that the degree to which nationally-based regulators needed to communicate and cooperate was comparatively limited. Indeed, only towards the end of the 1970s did various fora for international regulatory cooperation such as the Basle Committee on Banking Supervision begin to emerge.

Finally, as far as the specific techniques of supervision are concerned, the assessment of banks' capital adequacy is central to the traditional regulatory paradigm. The standard international assessment framework is the risk-assets ratio approach that was enshrined in the 1988 Basle Accord and that represented an international agreement between all the major bank regulators.⁶ Key to the risk-assets ratio is an attempt to monitor the prudential soundness of banks by using a standardized risk measurement framework that is applied to all institutions and that employs data based on a snap-shot of their balance sheets on certain specified reporting dates. The purpose is primarily to ensure that the bank maintains a sufficient capital cushion to absorb the losses that occur in the normal course of its business.

The first assumption underlying this approach is that there are features specific to banks that justify the need to regulate banking. These are usually explained as a combination of banks' unique position as the providers of the means of payment, the contagion risks inherent in interbank exposures, and the contagious effects of a loss of...