Financial Crisis and the
Paradox of Under- and
Over-Regulation
Joshua Aizenman
UC Santa Cruz & NBER
SER Conference
Singapore
August 7 2009
Paper’s agenda:
Endogenous regulation cycles
Explain the tendency to under
regulate in “good times,”
 Explain the risk associated with
overshooting the adjustment called
for following a financial crisis.
 Outline a regulatory structure that
mitigates the above concerns.

2
Financial integration in the last
30 years, developing countries
The 1980s - “lost development
decade.”
 The 1990s - growing optimism about
the globalization gains, trade
liberalization, coupled with financial
opening in LATAM (to a lesser degree
in Asia).

3
4
Vigorous debate about
financial opening.

Financial opening:
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Beneficial when the only distortion is restricting
intertemporal trade across countries,
Potentially damaging in the presence of other
distortions.
“Other distortions” -- moral hazard (MH),
an implicit subsidy to borrowing and
investment.
 MH: the “too big to fail” doctrine –


allowing large borrowers to go under triggers
systemic crisis
5
Financial innovations and financial
deregulation in the OECD countries

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Presumption – OECD’s superior financial
intermediation 
financial innovations are welfare improving.
The spell of “the great moderation” further
reduced concerns about the downside risk.
Concerns about principle-agent/ MH associated
with financial intermediation were swept aside.
“As we move into a new century, the market-stabilizing
private regulatory forces should gradually displace many
cumbersome, increasingly ineffective government
structures.” Alan Greenspan, FED Chair, April 12, 1997. 6
The unfolding global liquidity
crisis

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Illustrates the universality of MH and the “too big
to fail” doctrine.
Under regulating financial intermediation 
excessive risk taking, subsidized by tax payers’
financed bailing outs.
The magnitude of the global crisis: a surprise.
IMF 4-09 estimate of global toxic assets ~ $4 trill.
The high costs of the crisis  the pendulum of
financial integration shifts towards reversal.
7
High persistency of financial
policies.
 The
high co-movement of financial
integration indexes across countries,
and the persistence of policies
towards financial openness suggest
pendulum dynamics.
8
Under-regulation:
possible interpretation


Prudential regulator’s success or a prolonged
economic tranquillity leads to complacency
 lower demand for regulator’s services
 under regulation  … financial calamity.
 The identity of agents that benefit from crisis
avoidance is unknown;
yet regulation costs are transparent.
 Crises that have been avoided are imperceptible,
and are under-represented in the political
discourse.
The demand for regulation declines during
prolonged good times, thereby increasing the
ultimate cost of eventual crises.
9
Under-regulation: the model
Interaction of two types of uncertainty

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Financial reform takes place at time 0.
Financial reform may lead to a future crisis.
I. The crisis probability is adjusted overtime in a
Bayesian manner.
Costly regulation (r) reduces the Probability of
financial crisis; higher r  lower Pr.
II. Individual uncertainty: The majority is
exposed to a costly crisis with probability q < 1.
The minority is exposed to the crisis with
probability 1.
The majority determines the regulation.
10

Under-regulation: the model
Results

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Show conditions where the regulation level
supported by the majority is positive after the
reform, but below the socially optimal level.
Tranquil time reduces the regulation intensity,
as it reduces the posterior probability of a
crisis.
Long spell of no crisis  the regulation level
drops towards zero; while the socially optimal
regulation level remains positive.
11
Under-regulation: the model
Results, cont.

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Asymmetric information aggravates the
challenges facing the regulator.
Example: the public does not observe
regulator’s effort.
Higher regulator effort, helping to avoid a
crisis  would be confused as a signal of a
safer environment  reducing the posterior
probability of a future crisis  eroding the
support for costly future regulation.
12
Prudential over-regulation
Crisis resulting in unanticipated high costs
may induce over-regulation and
stagnation:
 Parties that would bear the cost of the
over regulation are under-represented in
the decision making process [can be
modeled applying Fernandez and Rodrik’s
AER (1991) status quo bias].

13
A regulatory structure that
mitigates these concerns

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Improving confidential information disclosure:
needed to allow assessment of systemic risk
triggered by “too big to fail” concerns.
Increasing the independence of the regulatory
agency from the political process; needed to
reduce under-regulating in good times.
Centralizing the regulatory process and
increasing its transparency; mitigates
asymmetric information problems.
Global standards of minimum prudential
regulation and information disclosure, enforced
by the domestic regulator; a commitment devise
mitigating under-regulation in good times, reducing
regulatory arbitrage between countries [see AIG…].
14
The probability of a crisis
following financial reform at t = 0

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The prior probability of crisis at t = 1 is P0,1 .
Costly investment in regulation at time
zero, r0 per agent reduces the probability
to P0,1  Q ; Q  Q( r0 ); Q '  0 ; Q(0)  1; Q  1
To fix ideas,
2 exp r0
Q( r0 ) 
1  exp  r0
15
The time line
No crisis:
P0,1  P1,2
(see Appendix).
16
Two groups, FE (fully exposed)
and PE (partially exposed)
17
Claims 1 & 2
 With positive regulation, the planner’s
regulation level is above the optimal level
set by the partially exposed (PE) group
[the majority].
 In an equilibrium with positive regulation;
the regulation rate increases
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the higher the perceived crisis probability, P;
the higher are crisis costs,
the higher is the effectiveness of regulation.
These factors increase the likelihood of
positive regulation.
18
A simulation: regulation level (r) and
the expected marginal benefit of
regulation, at time t = 0
[S: planner’s curve, PE: majority’s curve]
S
PE
19
Claim 3: good luck spell

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High efficacy of regulation
 the regulation set by the majority [PE group]
in time t = 0 is positive, but below the socially
optimal level. The under-regulation drops with
the share of exposed agents, q.
Tranquil time reduces the regulation intensity.
A long spell of no crisis
 regulation level drops towards zero;
yet the socially optimal regulation level
remains positive.
20
A simulation: regulation level (r)
and the expected marginal benefit
of regulation, a long spell of “good
time”
[S: planner’s curve, PE: majority’s curve]
S
PE
21
Claim 4: less informative prior
[assuming a simple discrete binomial pdf]
Less informative prior regarding the
probability of a crisis  the faster would
be the drop in regulations induced by a
“good luck” run.
 Thus, good luck runs are especially
damaging in the aftermath of
unprecedented financial reform, when
the public is exposed for the first time to
new financial instruments.

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Claim 5: asymmetric information
 The
public gets noisy signals about the
regulator's effort  Higher effort which
avoids a crisis would be confused as a
signal of a safer environment 
reducing the posterior probability of the
crisis, below the level of symmetric
information.
 Would erode the future support for
costly regulation.
 May increase the ultimate crisis cost.
23
Over-regulation hazard
 A crisis that leads to a cost of a higher
order of magnitude than the
anticipated one, may induce a
pendulum shift from under-regulation
to over-regulation.
24
Costly over regulation

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With repressed financial intermediation 
entrepreneurs that would have benefited from
financial intermediation, are under-represented in
the decision making.
This happens with individual-uncertainty regarding
the incidences of successful investment [analogues
to Fernandez and Rodrik (1991)].
Crisis outcome: increasing the risk of
Over-regulation  a static economy; the benefit
of crisis avoidance would come with a large
cost of stagnation, a cost that is underrepresented in the political discourse.
25
Regulatory changes needed to deal with
the challenges associated with under and
over-regulation

Information gathering: a necessary
condition for effective regulation is
mandatory periodic confidential reports of
the balance sheet exposure of all financial
institutions above a minimum size,
operating in the domestic market.

In the US, the BEA collects detailed
confidential info. about the real sector, but no
comparable disclosure of the financial
system…
26
Independence of the regulatory agency
from the political process and various
pressure groups
 Due
to principle-agent problems, the
regulator’s independence is needed
to avoid “regulatory capture.”

Interested parties prefer underregulation as a way to facilitate
excessive risk taking subsidized by the
tax payers. Rajan and Zingals (2003)
and Rajan (2005).
27
Centralizing the regulatory
process
A fractured regulatory process  each
agency focuses on its narrowest task,
viewing “ the big picture” as beyond its
mandate.
 Evaluating systemic risk requires
combining all the pieces of the financial
puzzle.
 Centralized regulatory process
minimizes regulatory arbitrage.

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Adopting global standards of minimum
prudential regulation and information
disclosure, enforced by the domestic
regulator.

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Global minimum standards increase the costs of
deregulation -- a commitment devise.
Minimum prudential standards mitigates
“regulatory arbitrage” across countries:
Under-regulation attracts capital inflows in search
of higher returns induced by the implicit subsidy
provided in more under-regulated countries.
AIG ‘s under-regulation allowed it to sell under-priced
insurance contracts to European institutions,
arrangements that were subsidized by US tax payers.
29
The models results are robust to
various extensions, including


Lobbying model instead of a ‘median voter.’
Non Bayesian agents, as may be the case if
people pay insufficient attention to low
probability risks of disaster before a crisis
happens, and too much attention right after.


See Viscusi (2009) and Tversky and Kahneman.
Continuous distribution of agents with
heterogeneous income and exposure, where the
median voter determines the regulation.
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Concluding remarks


The challenge: to adopt Goldilocks regulations,
mitigating the temptation to under-regulate in
spells of good time, preventing over-regulation
in the aftermath of a financial crisis.
The risk of not meeting these challenges:


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Some affected countries will opt to reduce their
financial integration;
Some will overshoot the regulatory adjustment
inducing lower future growth;
Others will remain exposed to the hazard of
replaying crisis dynamics in the future.
31
Thank you!