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Global Financial Trouble: Causes, Cures, Responses

May 15, 2009, 5:49 AM

(Contd from Tuesday's Issue)

Required Responses

Domestic regulation is often needed when firms do not bear all the risks of their actions or when the people who control firms do not bear all the risks of their actions. Furthermore, international regulation is needed when states do not bear all the risks of their regulatory actions. International externalities may occur through contagion: Financial institutions maintain dense international webs of interbank relationships, and the failure of one bank may hurt others. International externalities may also occur through regulatory competition: When one state reduces its standards, it may increase the short-term competitiveness of its financial institutions, imposing competitive harm on foreign financial institutions. Finally, a U.S. economic slump has knock-on effects around the world through the mechanism of trade and investment.

What kind of international regulatory response is required? States must take greater responsibility for the solvency regulation of their financial institutions in order to limit the risk of contagion. It may be appropriate for states to agree on the scope of this responsibility.

But this will not be enough. Corporate governance problems that induce firms to take excessive risk must be addressed, either through regulation or through self-regulation by the financial industry. An international regulatory response will be needed to ensure that states do not have incentives to reduce regulation in order to promote the competitiveness of their own firms. The Basel capital regulation was partially motivated by this concern, but much more work needs to be done.

Finally, greater sobriety and humility in macroeconomic management, and greater attention to the concerns of other states regarding national macroeconomic management, will be needed in order to avoid the conditions for asset bubbles or other macroeconomic-based crises.

The opinions expressed in this article do not necessarily reflect the views or policies of the U.S. government.

(This is a product of the Bureau of International Information Programs, U.S. Department of State. 

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