The regulatory pendulum has swung back towards intervention in the wake of the global financial crisis, prompting robust discussion about the role and scope of financial regulation, including the costs of regulation versus its benefits.
Associate Professor Gordon Menzies, of UTS Business School, says it's difficult to achieve a true cost-benefit analysis of financial system regulation. Instead, he proposes measuring the usefulness of a proposed regulation - or a regulation mooted for removal - in terms of its independence from other regulatory measures.
In a study funded by the Centre for International Finance and Regulation (CIFR), Dr Menzies introduces the concept of Independent Dimensions of Regulation (IDR) and provides a framework for assessing what might be the optimal amount of regulatory effort in seeking to avoid financial crises.
He offers the example of a central bank and an institutionally independent prudential regulator that both look at the same set of systemic stability issues. The two regulators can represent two IDRs if their data and review methodologies are sufficiently different such that were one regulator to miss a financial flaw it would not significantly reduce the chance that the other would find it.
Another example might be two independent areas of the same regulatory organisation performing stress tests on the same bank but using different assumptions and examining different data.
Together, these two examples show that institutional independence is neither sufficient nor necessary for statistical independence.
'Increasing the number of quality checks
on a production line exponentially decreases
the likelihood of a fault being missed'
Dr Menzies compares the idea of IDRs to quality control on a production line. “Increasing the number of quality checks on a production line exponentially decreases the likelihood of a fault being missed," he says. "Applying this concept to regulation, it follows that the likelihood of a negative shock emanating undetected from the banking system decreases rapidly as the number of independent checks increases. Conversely, the probability of a shock balloons as check numbers are reduced.”
He argues in his paper that if the number of IDRs is optimal, it is very costly to remove even one. Also, if the optimal number of IDRs is unknown, then removing one could prove risky. The Murray Financial Services Inquiry recommendation to leave intact separate APRA and RBA monitoring of the financial system is consistent with this latter principle.
Dr Menzies suggests that where cost-benefit analyses of quality control regulations are too onerous, authorities should group regulations that seem relatively independent into "clusters" and then use pure independence as the relevant conceptual benchmark.
“This approach seems more reasonable than a simple assumption that any duplication must be summarily removed, or that each and every claim of regulatory effectiveness has merit,” he says.
Dr Menzies concludes that where regulations are highly dependent, policy makers should strive for greater statistical independence – the ideal of multidimensional regulation.
You can download the Working Paper from CIFR's website.
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