Buffers or shock absorption in regulating finance

April 15, 2023

There are two main approaches to macroprudential regulations. The first is the current one of identifying all risks and using them to build buffers against shocks. Alternatively, shock absorption can be used to boost resilience. Which is better?

What can we learn from Silicon Valley Bank and Credit Suisse's failures?

One interpretation is that what went wrong was that the authorities did not identify the risk that led to the failure of those banks; consequently, the lesson learned is to plug those holes and hope that is all that is required. This is based on the modern philosophy of financial regulation, based on identifying all relevant risk and designing rules and buffers to prevent that risk from materialising.

The alternative is to strengthen the financial system by increasing shock absorption. Contrary to popular belief, the financial system is extremely resilient, capable of absorbing nearly all shocks. The authorities could use that inherent resiliency to increase shock absorption so that when a major failure, such as SVB or CS, occurs, the system can recover. This is easily accomplished by diversifying the institutions that comprise the financial system. The more different they are, the better the system is aggregate absorbs stocks. As a result, regulations can be less intrusive and costly. Lower systemic risk, lower regulatory costs, and higher economic growth would be the benefits.

That is not the lesson that is being learned. Expect more thorough risk assessments and larger buffers instead. This may temporarily calm markets, but it will be recessionary and increase systemic risk in the long run.

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