Regulation or Supervision: Challenges Ahead

The accounting and prudential norms that regulate financial intermediation have significantly evolved over the last twenty years. They have become aligned with the industry’s best practices, thereby gaining in sophistication and complexity. This generated procyclicality and created room for massive regulatory arbitrage. This in turn contributed to a large extent to the 2008 crisis. One can foreshadow two issues with current attempts at fixing this regulatory environment. First, the asymmetric tightening of banking and shadow-banking regulations may induce a massive migration of lending towards the more unstable shadow-banking system. Second, moving back to overly simplified prudential rules, such as the leverage ratio, may create important distortions in the allocation of capital. The most appropriate response to the crisis pertains to supervision rather than regulation in my view. An important investment in the human capital of supervisory authorities and a shift from « box-ticking » regulation towards more supervisory discretion are in order.