18th March 2014

A policy for better policymaking

Written by Adam Cull, the BBA’s Senior Director (Financial Policy and Operations)

The next meeting of the Financial Policy Committee (FPC) takes place tomorrow. As the members prepare, new research from the IMF on the regulatory response to the financial crisis should be on their reading list.

The paper may make for uncomfortable reading but its findings are striking. Several years after the height of the crisis the IMF concluded that “the financial reform agenda is still only half-baked at best”. Many reforms are “in conflict with one another or appear to have unintended consequences”.

Failings are traced back to shortcomings in the policymaking process. In particular:

Policymakers do not always discuss, assess or even recognise complexities and trade-offs between different policy objectives.

  • Initiatives to “fix” problems have a tendency to be ill-timed meaning they are either too slow and reforms back up, or too fast and the economy fails to recover. Balancing this requires “judgement and flexibility”.
  • There is a tendency when coordinating regulation “to adopt the lowest common denominator or to negotiate specific one-off exceptions”.
  • The approach to cost-benefit analysis follows too narrow a mind-set. Policymakers should think through the business cycle and acknowledge that “ever more complexity in rules has not just direct costs, but can even increase financial stability risks”
  • Too much rigidity in rules hinders future crisis management.

The paper identifies three basic lessons for policymakers to reduce systemic risk. Top of the list is thinking about the system as a whole. Only by considering reforms in their entirety can their impacts be shared fairly. Secondly, current regulations are failing to understand incentives. A “do no harm” oath should be adopted when seeking to fine tune policies.

Finally, risks and uncertainties will always be a feature as institutions consciously engage in a risk-return trade-off and there will always be unknown unknowns. This reinforces the need for a sensible plan B – good crisis management plans for when preventative measures fail.

The IMF praises the “promising” macro-prudential capabilities of bodies like the FPC but warns that “it is still too early to rely on them heavily”.

As the FPC meets to consider the threats to financial stability in the UK, the members would do well to consider the recommendations in this paper and how their actions will alter the incentives throughout the UK financial system.

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