Constraints to Improving Financial Sector Regulation

Following every major financial debacle (of which we now have had three in the span of a decade – the Asian crisis, the dot-com bubble, and the subprime crisis), all the parties that bear some responsibility for the soundness of financial institutions come under scrutiny – the managers (and their pay/incentive packages), the directors, the auditors, the rating agencies, the market analysts, the risk models, the whiz kid mathematics geniuses who build them, and of course the supervisory officials and the regulations they administer. Given the many past crises and the concerted efforts over the years to devise better regulatory frameworks, this paper argues that we are at a point of diminishing returns on additional expenditure of efforts on devising better standards and rules. The difficulties lie in administering the existing rules effectively. It observes that financial crises emerge out of the interaction between borrowers and lenders and between the demand for and the supply of instruments tailoring risk in a dynamic context of imperfect information, incomplete markets, herd behavior, and unpredictable shocks and responses. This generates a number of effects that make it difficult to refine the regulatory framework to prevent crises, however much practice we have had with such events.