The financial crisis of 2007 eroded the public confidence in financial markets. Many people have come to believe that only the government can guarantee the stability of financial markets. Responding to increased public demand, politicians from across the political spectrum support additional “macroprudential regulation”. However, little is known about the consequences of the newly proposed regulatory efforts. When politicians fear unforeseen consequences of regulation, they might turn to Placebo-regulation, which is some regulation that merely provides a warm glow for the general public. Given the widespread belief in the need for government regulation, we suggest that such Placebo-regulation may be a good option. Market distortions are avoided. But confidence in financial markets might be restored.
The so-called macroprudential regulation that aims at stabilizing the boom-and-bust cycle in financial markets has been at the heart of the debate on financial regulation in the aftermath of the financial crisis. Prudential regulation sounds great at first. But little is known about its effects: Economists only have access to restricted samples for examining the impact of macroprudential regulation empirically. Model and parameter uncertainty is an issue. Predictions are unreliable. In addition, it is hard to foresee how market participants would react to suggested changes. For example, shadow banking could expand if banks faced stricter regulation. An overly extensive regulation can undermine the proper functioning of financial markets and impede economic development. It is, therefore, not easy for politicians to identify the best available measures. This implies that there are risks and potential costs. But there is a public demand for such regulation.
Public Demand for Financial Regulation in Germany
Source: Statistia, ARD-Germany Trend 2011.
To prevent negative consequences of financial regulation and, at the same time, signal action to the concerned public policymakers might (and sometimes do) revert to regulation that can be easily circumvented or introduce instruments that will not be applied. That’s Placebo-regulation. Several famous examples come to mind: The German Ring Fencing Act (Trennbankengesetz), a German-type Glass-Steagall Act, was often identified as a Placebo by critics because the so-called Proprietary Trading was defined as narrow as possible (to prevent potential market disruptions from overregulation). Market participants also considered Europe’s short-selling ban ineffective because it may be easily circumvented. Critics of such loopholes maintain that the financial lobby prevented a stricter regulation. And there is probably some truth to this. However, we suggest that given the knowledge problem in prudential regulation and the strong belief in government regulation, Placebo-regulation may be the way to go. Placebo-regulation allows politicians to please the general public by giving the comforting impression that something is being done. Trust in financial markets is restored. At the same time, negative consequences are, by and large, avoided.
The Countercyclical Capital Buffer: Another Less Obvious Placebo?
Policy economists also came up with the so-called Basel-III package that politicians happily accepted and point to in order to show action. We find that within Basel III, for instance, the countercyclical capital buffer adopted by the European Union in 2016 might well turn out to be a Placebo. The countercyclical capital buffer is an instrument that shall be used to force banks to accumulate capital beyond the compulsory capital requirement when there is a credit boom. In the EU, the respective national supervision authorities decide on the level of the buffer (between 0 and 2.5 percent). The idea of the additional buffer is, of course, to mitigate excessive credit supply by banks during upswings and to reduce the risk of another financial crisis. However, too high a buffer would be harmful.
But how do we know with certainty when we enter a credit boom? A rapid increase in credit supply can be sustainable if it is driven by promising innovation or deepening of financial markets. By contrast, a crisis is easily identified. This knowledge problem makes it difficult for authorities to employ the buffer symmetrically in boom and bust without causing unnecessary distortions. Reasonable authorities will lower the buffer rapidly in a crisis without raising it accordingly during boom periods. Given its current level of zero percent in all euro area countries but Slovakia (where the buffer is at 0.5 percent), the buffer is hardly used. It is probably for the better.
Placebos May Justify Costs
To the extent that Placebo-regulation strengthens the public confidence in financial markets and satisfies the ambitions of certain politicians, such regulative efforts might justify bureaucratic costs. At least in the short-run, an increase in trust in financial markets has a positive impact on the stability of financial markets. As Placebo-regulation offers politicians a way to increase their popularity, we might hope that through such Placebos fewer interventions are made that harm markets than otherwise would be the case.