Procyclicality Of Financial Regulation And How To Deal With It - Charles Goodhart | Summary and Q&A

TL;DR

Financial regulation tends to be procyclical, tightening during busts and loosening during booms, and there is a need for new approaches and measures to address this issue.

Key Insights

• ❓ Financial regulation tends to tighten during economic downturns, which can amplify the downturn.
• ⛔ Regulations can have a restrictive effect on growth and limit innovation in the financial sector.
• 💥 Market forces make regulations more easily met and less restrictive during economic booms.
• 🤑 Current developments in Europe, such as increasing capital requirements, can lead to a deleveraging process and reduction in the money stock.
• 🥳 Measures to address the procyclicality of financial regulation include counter-cyclical capital requirements and a new approach to ratio controls.
• 🏦 Ownership and governance arrangements should be considered as banks become riskier, with a shift towards stakeholders such as bondholders and the government.

Transcript

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Questions & Answers

Q: Why does financial regulation tend to be procyclical?

Financial regulation is reactive, tightening in response to crises, but this often happens when the economy is weakest, leading to a further downturn.

Q: How does regulation restrict innovation?

Regulations limit certain forms of innovation and spur other forms of innovation to get around the regulations, resulting in a less innovative financial sector.

Q: What are the effects of tightening capital requirements during a financial downturn?

Tightening capital requirements can lead to a deleveraging process and reduce the money stock, making it more difficult for banks to raise new equity and potentially affecting the overall economy.

Q: How can procyclicality of financial regulation be addressed?

Measures such as counter-cyclical capital requirements can be implemented, but they need to be based on presumptive indicators of fragility to be effective. A new approach to ratio controls, with higher and lower ratios and ladder of sanctions, could also be considered.

Summary & Key Takeaways

• Financial regulation tends to react to crises by tightening restrictions, but this often exacerbates the economic downturn.

• Regulations can limit innovation and have a restrictive effect on growth.

• Market forces also make regulations procyclical, with regulations being more easily met and less restrictive during booms.

• Current developments in Europe, such as the increase in capital requirements, can lead to a deleveraging process and reduce the money stock.