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Financial Crisis and the Paradox of Under- and Over-Regulation

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  • Joshua Aizenman

Abstract

This paper illustrates the paradox of prudential under-regulation in an economy that adopts financial reform, a reform which exposes the economy to future financial crises. There is individual-uncertainty about the crisis incidence, and the probability of the crisis is updated sequentially applying Bayesian inference. Costly regulation can mitigate the probability of the crisis. We identify conditions where the regulation level supported by the majority is positive after the reform, but below the socially optimal level. Tranquil time, when the crisis would not take place, reduces the regulation intensity. If the spell of no crisis is long enough, the regulation level may drop to zero, despite the fact that the socially optimal regulation level remains positive. The less informative is the prior regarding the probability of a crisis, the faster will be the drop in regulations induced by a no-crisis, good luck run. The challenges facing the regulator are aggravated by asymmetric information, as is the case when the public does not observe regulator's effort. Higher regulator effort, while helping avoiding a crisis, may be confused as a signal that the environment is less risky, reducing the posterior probability of the crisis, eroding the support for costly future regulation. The other side of the regulation paradox is that crisis resulting with unanticipated high costs may induce over-regulation and stagnation, as the parties that would bear the cost of the over regulation are underrepresented in the decision making process. We also outline a regulatory structure that mitigates the above concerns, including information disclosure; increasing the independence of the regulatory agency from the political process; centralizing the regulatory process and increasing its transparency; and adopting global standards of minimum prudential regulations and information disclosure, enforced by the domestic regulator.

Suggested Citation

  • Joshua Aizenman, 2009. "Financial Crisis and the Paradox of Under- and Over-Regulation," NBER Working Papers 15018, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:15018
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    1. Ricardo J. Caballero & Arvind Krishnamurthy, 2008. "Collective Risk Management in a Flight to Quality Episode," Journal of Finance, American Finance Association, vol. 63(5), pages 2195-2230, October.
    2. Joshua Aizenman, 2004. "Financial Opening: Evidence and Policy Options," NBER Chapters,in: Challenges to Globalization: Analyzing the Economics, pages 473-498 National Bureau of Economic Research, Inc.
    3. Takatoshi Ito & Anne O. Krueger, 1996. "Financial Deregulation and Integration in East Asia, NBER-EASE Volume 5," NBER Books, National Bureau of Economic Research, Inc, number ito_96-1, June.
    4. Michael P. Dooley & Inseok Shin, 1999. "Private inflows when crises are anticipated: a case study of Korea," Proceedings, Federal Reserve Bank of San Francisco, issue Sep.
    5. Demirguc-Kent, Asli & Detragiache, Enrica, 1998. "Financial liberalization and financial fragility," Policy Research Working Paper Series 1917, The World Bank.
    6. Paola Bongini & Stijn Claessens & Giovanni Ferri, 2001. "The Political Economy of Distress in East Asian Financial Institutions," Journal of Financial Services Research, Springer;Western Finance Association, vol. 19(1), pages 5-25, February.
    7. Raghuram G. Rajan, 2005. "Has financial development made the world riskier?," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, issue Aug, pages 313-369.
    8. Joshua Aizenman & Ilan Noy, 2009. "Endogenous Financial and Trade Openness," Review of Development Economics, Wiley Blackwell, vol. 13(2), pages 175-189, May.
    9. Ronald I. McKinnon & Huw Pill, 1996. "Credible Liberalizations and International Capital Flows: The "Overborrowing Syndrome"," NBER Chapters,in: Financial Deregulation and Integration in East Asia, NBER-EASE Volume 5, pages 7-50 National Bureau of Economic Research, Inc.
    10. Fernandez, Raquel & Rodrik, Dani, 1991. "Resistance to Reform: Status Quo Bias in the Presence of Individual-Specific Uncertainty," American Economic Review, American Economic Association, vol. 81(5), pages 1146-1155, December.
    11. Kevin C. Murdock & Thomas F. Hellmann & Joseph E. Stiglitz, 2000. "Liberalization, Moral Hazard in Banking, and Prudential Regulation: Are Capital Requirements Enough?," American Economic Review, American Economic Association, vol. 90(1), pages 147-165, March.
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    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. Regulation and the financial crisis
      by Economic Logician in Economic Logic on 2009-06-10 13:48:00

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    Cited by:

    1. T.V.S. Ramamohan Rao, 2010. "Financial crisis, efficient bailouts, and regulatory policy," Macroeconomics and Finance in Emerging Market Economies, Taylor & Francis Journals, vol. 3(2), pages 167-188.
    2. Miroslava Filipović, 2011. " Exigency Politics or New World Order?," Panoeconomicus, Savez ekonomista Vojvodine, Novi Sad, Serbia, vol. 58(3), pages 373-391, September.
    3. Gazi Kara, 2016. "Bank Capital Regulations Around the World : What Explains the Differences?," Finance and Economics Discussion Series 2016-057, Board of Governors of the Federal Reserve System (U.S.).
    4. Marko Malovic, 2009. "International Financial Crisis, G-20 And Global Policy Response," Montenegrin Journal of Economics, Economic Laboratory for Transition Research (ELIT), vol. 5(10), pages 119-127.
    5. Adalbert Winkler, 2012. "The Financial Crisis: A Wake-up Call for Strengthening Regional Monitoring of Financial Markets and Regional Coordination of Financial Sector Policies?," Chapters,in: Implications of the Global Financial Crisis for Financial Reform and Regulation in Asia, chapter 7 Edward Elgar Publishing.
    6. Mariko Fujii, 2010. "Securitized Products, Financial Regulation, and Systemic Risk," Working Papers id:3007, eSocialSciences.
    7. Mariko Fujii, 2010. "Securitized Products, Financial Regulation, and Systemic Risk," Finance Working Papers 23010, East Asian Bureau of Economic Research.

    More about this item

    JEL classification:

    • E02 - Macroeconomics and Monetary Economics - - General - - - Institutions and the Macroeconomy
    • F02 - International Economics - - General - - - International Economic Order and Integration
    • F15 - International Economics - - Trade - - - Economic Integration
    • F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration
    • F42 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Policy Coordination and Transmission

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