Anaylsis on Regulation Vs Supervision
Which Works Better - Regulation Or Supervision?
The globalization of financial markets, the dramatic increase in trade and capital flows in the world has deepened economic and financial integration among all countries, and it creates a more complex financial environment, with a greater diversity of capital flows, creditors and borrowers. This process of globalization creates new opportunities but also challenges the international community, especially with regard to the international monetary and financial system. Comprehensive and effective financial regulation, market-reinforced prudential supervision and enhanced international cooperation among regulators are among the keystones for maintaining stability of the international financial and monetary system.
Financial regulation has traditionally proceeded through the route of setting standards and of externally imposing rules. Setting standards, however, is only the first step in accomplishing effective regulation. The hardest part is designing a structure of incentives and sanctions that will induce financial intermediaries to live up to agreed standards of behavior. Regulation that is too tough can stifle innovation, and overprotection can lead to the loss of management accountability. Therefore, regulation should primarily make the market work. Importantly, an empirical relationship is established confirming that overall financial legal scope and effectiveness do have significant explanatory power for the size of financial markets. Again, economic considerations play a great role in the new regulatory framework. Explicit cost-benefit analysis leads towards evidence-based policymaking. The persistence and strengthening of competition in a functioning market is essential.
Financial safety nets are generally supported by prudential regulations that require banks to hold enough capital to absorb losses and by reporting and accounting standards and best business practices that ensure that losses are reflected in profit and loss statements. Although this approach has worked reasonably well in limiting systemic damage from financial excesses, it may lead to conflicts between the objectives of regulators, who, by providing insurance, want to reduce systemic risks, and those of the regulated institutions, which have incentives to take greater risks within internal and regulatory capital constraints. There are dangers both in excessively restrictive regulations, which may inhibit efficiency-enhancing risk taking, and in lax enforcement, which might encourage financial institutions to take risks that would not be worth taking in a different environment. There is no definitive solution to this problem, and it is neither possible nor desirable for financial supervisors and regulators to know as much about a financial institution and its risk-taking activities as its own management. Nevertheless, they must...