Rules Vs. Discretion

Ensuri ng financial stability is the goal of both regulators and governments. The cornerstone for financial stability is regulatory supervision of financial entities. Supervision can either be rules based – which essentially provides a level playing field to all entities under regulation, or discretionary, where the institution can choose the methodology from a basket of options.

The history of financial regulation started off with a rules based approach – like what we have in India at present – the same set of regulation applicable to all entities. But as we pushed the frontiers of financial modeling institutions wanted the ability to choose their models.

The burden was shifting from a uniform methodology, driven by the regulator to a more egalitarian approach, where the bank chooses the method, gets the regulator’s approval and goes ahead. This is like a self evaluation. The recent LIBOR fixing scandal, where a few banks were caught fixing the LIBOR rates is a case in point. Unless you are an extremely honest individual, self regulation will not work.

Today the regulators are talking of a dual track LIBOR. However, when it comes to banking, regulators somehow prefer self regulation. The Basel guidelines – from Basel I to Basel III – are a perfect example of self regulation. The Basel guidelines are a classic case of moving from simple regulatory rules to complex self regulatory discretion. From a 30 page document and five risk weights, Basel III has become a 600 odd page document with more than 200,000 risk weights.