Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

US regulatory framework and light touch regulation

An IMF working paper published this month forced me to rethink the
often repeated contrast between the heavy handed rule based US
regulatory framework and the light touch principles based system in
the UK. The paper New
Landscape, New Challenges: Structural Change and Regulation in the
U.S. Financial Sector
by Ashok Vir Bhatia argues that the US
financial sector is divided into a tightly regulated core and a
loosely regulated periphery. The tightly regulated core consisting of
the banks and depository institutions, the housing sector federal
agencies and the big five investment banks today account only for a
third of the US financial assets. The remaining two-thirds of the
assets are in the periphery which is subject to Bernanke’s
regulation
by the invisible hand
” of market discipline.

Bhatia argues in particular that “the Fed [serves] a
singular role as guardian against more dirigiste temptations.” I
think this is an important point – there is little doubt that
the US Fed has a significantly lighter touch regulatory mindset than
the US SEC. This is also an aspect that is often missed in the simple US
versus UK dichotomy of rules versus principles based regulation.

Where the rules based approach is most dominant in the United
States is in the area of consumer protection which is of course
dominated by the SEC. The UK has shown the way in applying principles
based regulation even here and this is a model that is worth
emulating. However, the US model shows how great the benefits are of a
light touch regulation applied only to the periphery. The vibrancy of
the US financial sector is due doubtless to this light touch. For
countries like India whose financial sector is repressed by heavy
handed regulation, applying light touch to the periphery is a low
hanging fruit that can be plucked quite easily and with low risk.

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