Thursday, November 17, 2011

Is light-touch regulation passé?

by Lucia Dalla Pellegrina and Donato Masciandaro


November 17, 2011

Following the crisis of 2008–09 a period of banking-sector vulnerability occurred in many countries. To what extent did this vulnerability result from light-touch banking regulation? This column examines the ‘unpleasant nexus’ between volatility and light-touch regulation and argues that the crisis proved that such regulation may not be able to reduce systemic risk to acceptable levels.

During the Great Moderation stable growth was associated with a high level of certainty with regard to the general framework in which economic agents were operating, both cyclically and structurally. At the structural level, an important role was given to improving market regulation, which was itself part of a more effective system of public governance (Kaufmann et al 2002). The regulation paradigm was clear: the more market-friendly – ie, the more light-touch – the better. Regulation should foster an environment that makes individual risk-taking easier, by contributing directly to the efficient allocation of resources at the microeconomic level which, in turn, leads to steady growth at the aggregate level. The relationship between stable growth and well-designed rules was supported by theory and by empirical research (see, for example, Acemoglu et al 2005, Barth et al 2004 and Levine 2005a).

How the crisis called light-touch regulation into question

The crisis shattered this prevailing framework, to the extent that light-touch regulation – designed in order to optimise individual risk-taking – can be seen to have produced a negative externality by creating greater systemic risk and, therefore, a cost in terms of the volatility of growth itself. If there were robust clues to the existence of a correlation between light-touch regulation and the fall in growth, we could infer that such regulation does not automatically warrant optimal risk-taking, at least from a systemic point of view, as it had previously been assumed until 2007.

The issue of country vulnerability to the crisis has only recently entered the arena of economic analysis and has been conducted, until now, at a purely empirical level. A number of cross-section studies covering a large number of economies (see Dalla Pellegrina and Masciandaro forthcoming) reveal that regulation appears to be robustly associated with resilience. But this result is rather surprising, given that light-touch regulation appears to be inversely correlated with resilience.


1 comment:

  1. Good Morning Professor Hatzis. I Find the Column of Pellegrina and Masciandaro very interesting. Specially because it gives us a glimp of the outcome of their current research.

    I would like to add that one of the factors that has motivated this irrational risk-taking behavior is the knowledge of the agents of their too-big-to-fail status. It will be interesting to include this variable into analysis. common sense tells me that in a framework where the agents know their are NOT gonna be Bailed Out,they are less likely of taking high risk. Even in the presence of Light Touch Regulation.

    It will be interested to know whether empirical data support common sense.


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