Financial regulation and risk (2)

Here is a bit more on the conundrum of regulating financial risk when you know you shouldn’t, really. My message is that regulators should aim to encourage market-driven self-regulation.

I should perhaps remind you that I am not a professional economist, still less are my remarks here endorsed by either of the thinktanks I work with. You will think – perhaps – that this item on BBC Radio 4’s Today (25 September 2009)  programme is a useful background to what I say. I did.

(1) The background
Governments in Anglo-Saxon or Anglophone markets sense that they should do very little, else they risk creating moral hazard. That’s true whether they guarantee firms against collapse or regulate them against risk. Either makes Alpha Male firms cocky, which we wouldn’t mind provided there was plenty of fear about too.

(2) Since governments find themselves protecting “innocent” consumers and the total financial system, they are involved in last resort rescue, and so they get into regulation to reduce consumer and systemic risk.

(3) How to regulate in the best way (ideally)
One is to force firms to advertise their riskiness. That is, to speak frankly about how prone to disaster they are. (Yes, I know: in the case of CDOs, etc.,  they actually didn’t know how prone they were. But if we lived in a less regulated environment, the media and ratings agencies would have demanded more sceptical interrogation of their mysteries, which might have revealed themselves.)

 (4) But what regulation look like in the real world?
I imagine that regulation would work best which looked most like what the regulator imagined an unregulated market would produce. Cross-industry guarantees, insurance against collapse, etc.

(5) How to get it?
Instead of writing lots of rules which must be obeyed, the best regulators would name and shame firms and sectors which had not produced the sorts of voluntary schemes which offered appropriate (always optimum, not always maximum) safety. Those warnings would then reinforce the market’s tendency to produce satisfactory safety. The firms and sectors which were exposed would see custom drying up or stakeholders demand premiums, etc.