Reforming the Financial System: Beyond Standardization on “Best Practice” Models

Posted by on 2 February 2009

As the world embarks on yet another attempt to reform the international financial system it is worth recalling what happened the last time; to assess these measures with the benefit of hindsight, and perhaps most importantly, to question the underlying assumptions on which these reform models rested.

The East Asian financial crisis of 1997/8, which quickly spread to other emerging markets triggered the IMF’s attempt to build an “international financial architecture” by standardizing domestic rules and regulations. This strategy rested on the assumption that ‘bad institutions’ in the countries that were afflicted by the crisis were to blame for their plight. The IMF assembled ‘best practice’ rules for protecting investor and creditor rights and regulating financial intermediaries. It embarked on financial sectors assessment programs (FSAPs), whereby countries were benchmarked against these standards and advised to change their laws and regulations to comply. The World Bank endorsed a similar approach to legislation in the areas of business law.

When applied to the global crisis the same reasoning would point to a major overhaul of the institutions in the US and the UK today. These were, of course, the same countries that served as ‘best practice’ models. Not surprisingly, the UK received high marks in the last FSAP conducted in 2003. The US refused to be subjected to FSAP treatment, but undoubtedly would have received similarly high marks.

The major argument against standardization as the cure all for financial crisis, however, is not that the wrong model was chosen. Nor is it the most common critique of legal standardization, namely that one model does not fit all. Instead, the idea that effective market regulation can be achieved by standardizing rules and regulations on the most successful model at the time is deeply flawed for the following reasons. First, it treats legal institutions as endowments and ignores the need for maintenance and adaptation not only to local conditions, but also to future change. Second, it creates the illusion that a given market is institutionally sound and thereby disguises problems that may trigger future crises. Third, the selection of ‘best practice’ models tends to reward regulatory regimes based on simple quantitative outcome variables, such as market size, even when market size may be the product of a bubble, while ignoring volatility and other risk factors.

A new strategy for financial market regulation should be based on the following principles:

- Diversification: Experimentation with alternative regulatory approaches is more likely to produce solutions to new problems than standardizing rules on a single, but potentially flawed, model. Assessments of regulatory regimes could follow a “comply or explain” strategy as an alternative to benchmarking. Moreover, policy makers should play a greater role in disseminating alternative models and explaining their trade-offs rather than endorsing a single one.

- Systemic risk management: Regulation should focus on systemic risk management rather than incentives of market participants. The current crisis evidences the inability of market participants to fully internalize the costs of their actions, and by implication, the market’s inability to regulate itself. Regulation designed to prevent future crises will by definition conflict with the incentives of self-interested market participants. Insisting that this is market ‘distorting’ misses the very purpose of regulation. The real question is whether a given regime strikes a reasonable balance between risk management and market development. For this, market size may be less telling than market volatility or new strategies capable of identifying self-enforcing processes that add to market instability.

- Responsiveness: It has long been noted that the history of financial markets is a history of financial market crises. Similarly, the history of financial market regulation has been a history of post-crisis regulatory reforms. The scale of the global crisis and its fallout for people around the globe calls for a new regulatory model. Rather than treating laws and regulations as fixed endowments that incorporate lessons from the past, a process-oriented strategy is needed that emphasizes continuous monitoring and adaptation of regulatory responses to changes in the market place. A major challenge will be to design systems that ensure the much needed participation of market actors while mitigating the danger of capture.

Katharina Pistor
Michael I. Sovern Professor of Law
Columbia Law School