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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. Regulation and the financial crisis
      by Economic Logician in Economic Logic on 2009-06-10 13:48:00

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    2. Gazi I. 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.).
    3. 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.
    4. 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: Masahiro Kawai & David G. Mayes & Peter Morgan (ed.), Implications of the Global Financial Crisis for Financial Reform and Regulation in Asia, chapter 7, Edward Elgar Publishing.
    5. Layal Mansour, 2012. "Hoarding of International Reserves and Sterilization in Dollarized and Indebted Countries : an effective monetary policy?," Working Papers 1208, Groupe d'Analyse et de Théorie Economique Lyon St-Étienne (GATE Lyon St-Étienne), Université de Lyon.
    6. Johannes Matschke, 2021. "National Interests, Spillovers and Macroprudential Coordination," Research Working Paper RWP 21-13, Federal Reserve Bank of Kansas City.
    7. Aizenman, Joshua, 2012. "The Euro and the global crises: finding the balance between short term stabilization and forward looking reforms," Santa Cruz Department of Economics, Working Paper Series qt8mc1z1wc, Department of Economics, UC Santa Cruz.
    8. Francesco Marchionne & Beniamino Pisicoli & Michele Fratianni, 2017. "Regulation, financial crises, and liberalization traps," Mo.Fi.R. Working Papers 143, Money and Finance Research group (Mo.Fi.R.) - Univ. Politecnica Marche - Dept. Economic and Social Sciences.
    9. Joshua Aizenman, 2011. "Trilemma and Financial Stability Configurations in Asia," Finance Working Papers 23219, East Asian Bureau of Economic Research.
    10. 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.
    11. Miroslava Filipović, 2011. "Exigency Politics or New World Order?," Panoeconomicus, Savez ekonomista Vojvodine, Novi Sad, Serbia, vol. 58(3), pages 373-391, September.
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    13. Mariko Fujii, 2010. "Securitized Products, Financial Regulation, and Systemic Risk," Working Papers id:3007, eSocialSciences.
    14. Uribe Gil, Jorge Mario & Ulloa Villegas, Inés Maria, 2012. "La medición del riesgo en eventos extremos. Una revisión metodológica en contexto," Revista Lecturas de Economía, Universidad de Antioquia - CIE, June.
    15. Mariko Fujii, 2010. "Securitized Products, Financial Regulation, and Systemic Risk," Finance Working Papers 23010, East Asian Bureau of Economic Research.

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    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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