The Anglo-Saxon model of supervision and regulation of the financial system has failed

Promoters of the laissez-faire economics have successfully chipped away at a range of regulations and enforcement of regulations of our financial institutions over the past several years. Their argument has been that the markets will somehow self-regulate and, when things go bad, correct themselves. The assumption is that an economy is not man-made but ruled by laws of nature. It also makes negative economic impact on people as a secondary concern, if a concern at all. And, as we have witnessed with the downward spiral of economies around the world, the idea that markets will self-regulate is a real stretch. Financial institutions have been given a free hand and look where we are.

Nouriel Roubini believes the Anglo-Saxon model of supervision and regulation of the financial system has failed and needs to be addressed:

To paraphrase Churchill, capitalist market economies open to trade and financial flows may be the worst economic regime--apart from the alternatives. However, while this crisis does not imply the end of market-economy capitalism, it has shown the failure of a particular model of capitalism. Namely, the laissez-faire, unregulated (or aggressively deregulated), Wild West model of free market capitalism with lack of prudential regulation, supervision of financial markets and proper provision of public goods by governments.

There is the failure of ideas--such as the "efficient market hypothesis," which deluded its believers about the absence of market failures such as asset bubbles; the "rational expectations" paradigm that clashes with the insights of behavioral economics and finance; and the "self-regulation of markets and institutions" that clashes with the classical agency problems in corporate governance--that are themselves exacerbated in financial companies by the greater degree of asymmetric information. For example, how can a chief executive or a board monitor the risk taking of thousands of separate profit and loss accounts? Then there are the distortions of compensation paid to bankers and traders.

This crisis also shows the failure of ideas such as the one that securitization will reduce systemic risk rather than actually increase it. That risk can be properly priced when the opacity and lack of transparency of financial firms and new instruments leads to unpriceable uncertainty rather than priceable risk.

It is clear that the Anglo-Saxon model of supervision and regulation of the financial system has failed. It relied on several factors: self-regulation that, in effect, meant no regulation; market discipline that does not exist when there is euphoria and irrational exuberance; and internal risk-management models that fail because, as a former chief executive of Citigroup put it, when the music is playing, you've got to stand up and dance.

Furthermore, the self-regulation approach created rating agencies that had massive conflicts of interest and a supervisory system dependent on principles rather than rules. In effect, this light-touch regulation became regulation of the softest touch.

Thus, all the pillars of the 2004 Basel II banking accord have already failed even before being implemented. Since the pendulum had swung too much in the direction of self-regulation and the principles-based approach, we now need more binding rules on liquidity, capital, leverage, transparency, compensation and so on.

But the design of the new system should be robust enough to counter three types of problems with rules. A tendency toward "regulatory arbitrage" should be kept in mind, as bankers can find creative ways to bypass rules faster than regulators can improve them. Then there is "jurisdictional arbitrage," as financial activity may move to more lax jurisdictions. And, finally, "regulatory capture," as regulators and supervisors are often captured--via revolving doors and other mechanisms--by the financial industry. So the new rules will have to be incentive-compatible, i.e., robust enough to overcome these regulatory failures.

You can read his entire article here.