The following post comes to us from Marcelo M. Prates, an Attorney at the Central Bank of Brazil.  The full article, which is now published as the Central Bank of Brazil Working Paper no. 335 and has been recently noted in the print edition of The Economist (which can be found here), is available here.

Since the onset of the 2008 financial crisis, there has been a great deal written about the regulation of the financial sectors. A lot of writings in blogs, sites, newspapers, magazines and journals call for more or better regulation.

It looks like everybody is concerned only with creating new and improved rules, which is just the first part of the regulation process. Few people seem to be worried about how these rules will be enforced and what the consequences will be if they are not observed or even fail, again, to meet their ends. In fact, enforcement seems to be a hidden side of financial regulation nowadays.

Despite all the fuss, I believe there are some issues related to the subject that deserve more attention than they have received so far, as discussed in my recent article, “Why Prudential Regulation Will Fail to Prevent Financial Crises: A Legal Approach.”

At the beginning, I suggest that the difficulty of regulating the financial system results not only from its nature and dynamics, but also from the process of creating rules itself.  In addition, I stress the complexities regarding the enforcement of financial regulation, particularly in a setting of overregulation. The article points out some of the troubles that the financial system supervisors may face in doing a proper oversight of all the institutions that matter and also in searching for the right measure to punish the institutions that fail to observe the relevant rules.

Based on this initial appraisal, I advocate that the regulation of the financial system, especially if the aim is to prevent financial crises, should be focused on dealing with the consequences of the crises, not on trying to avoid their causes, although it may seem counterintuitive at first sight. Contrary to the majority of opinions in the field, I firmly believe that more important than organizing the best possible prudential regulation is having a solid and well-developed financial safety net.

Building a strong safety net might not only boost confidence in the financial system and contribute to its stability, but also create the right incentives to avoid reckless risk-taking and better align interests, mainly if there are rules establishing that other financial institutions, creditors, and even executives could be held responsible for the trouble caused by any failed financial institution.