For Diversity in the International Regulation of Financial Institutions: Critiquing and Recalibrating the Basel Architecture

Abstract

This Article challenges the prevailing view of the efficacy of harmonized international financial regulation and provides a mechanism for facilitating regulatory diversity and experimentation within the existing global regulatory framework, the Basel Accords. Recent experience suggests that regulatory harmonization can increase, rather than decrease, systemic risk, an effect that is the precise opposite of the objective of harmonization. By incentivizing financial institutions worldwide to follow broadly similar business strategies, regulatory error contributed to a global financial crisis. Furthermore, the dynamic nature offinancial markets renders it improbable that regulators will be able to predict with confidence what are the optimal capital requirements or what other regulatory policies would reduce systemic risk. Nor, as past experience suggests, is it likely that regulators will be able to predict which future financial innovations, activities or institutions might generate systemic risk. The Article contends, accordingly, that there would be value added from increasing the flexibility of the international financial regulatory architecture as a means of reducing systemic risk. It proposes making the Basel architecture more adaptable by creating a procedural mechanism to allow for departures along multiple dimensions from Basel while providing safeguards, given the limited knowledge that we do possess, against the ratcheting up of systemic risk from such departures. The core of the mechanism to introduce diversity into Basel is a peer review of proposed departures from Basel, and, upon approval of such departures, ongoing monitoring for their impact on global systemic risk. If a departure were found to increase systemic risk, it would be disallowed. Such a diversity mechanism would improve the quality of regulatory decision-making by generating information on which regulations work best under which circumstances. It would also reduce the threat to financial stability posed by regulatory errors that increase systemic risk by reducing the likelihood that international banks worldwide will follow broadly similar, mistaken strategies in response to regulatory incentives.