There are a number of causes of the financial crisis that has devastated the U.S. economy and spread globally. Weakness in financial sector regulation was one of the causes and the proliferation of different regulators is, in turn, a cause of the regulatory failure. There is a bewildering, alphabet soup variety of regulators and supervisors for banks and other financial institutions that failed in their task of preventing the crisis and, at the same time, created an excessive regulatory burden on the industry because of overlapping and duplicative functions.

We can do better. This paper makes the case for a single micro prudential regulator, that is to say, one federal agency that has responsibility for the supervision and regulation of all federally chartered banks and all major non-bank financial institutions. There would still be state-chartered financial institutions covered by state regulators, but the federal regulator would share regulatory authority with the states.

The Objectives Approach to Regulation

The Blueprint for financial reform prepared by the Paulson Treasury proposed a system of objectives-based regulation, an approach that had been previously suggested and that is the basis for regulation in Australia. The White Paper prepared by the Geithner Treasury did not use the same terminology, but it is clear from the structure of the paper that their approach is essentially an objectives-based one, as they lay out the different elements of regulatory reform that should be covered. I support the objectives approach to regulation.

There should be three major objectives of regulation, as follows.

• To make sure that there is micro-prudential supervisions, so that customers and taxpayers are protected against excessive risk taking that may cause a single institution to fail.

• To make sure that whole financial sector retains its balance and does not become unstable. That means someone has to warn about the build up of risk across several institutions and perhaps take regulatory actions to restrain lending used to purchase assets whose prices are creating a speculative bubble.

• To regulate the conduct of business. That means to watch out for the interests of consumers and investors, whether they are small shareholders in public companies or households deciding whether to take out a mortgage or use a credit card.

In applying this approach, it is vital for both the economy and the financial sector that the Federal Reserve has independence as it makes monetary policy. Experience in the United States and around the world supports the view that an independent central bank results in better macroeconomic performance and restrains inflationary expectations. An independent Fed setting monetary policy is essential.

An advantage of objectives-based regulation is that it forces us to consider what are the “must haves” of financial regulation—those things absolutely necessary to reduce the chances of another crisis. Additionally we can see the “must not haves”—the regulations that would have negative effects. It is much more important to make sure that the job gets done right, that there are no gaps in regulation that could contribute to another crisis and that there not be over-regulation that could stifle innovation and slow economic growth, than it is that the boxes of the regulatory system be arranged in a particular way. In turn, this means that the issue of regulatory consolidation is important but only to the extent that it makes it easier or harder to achieve the three major objectives of regulation efficiently and effectively.

For objectives-based regulation to work, it is essential to harness the power of the market as a way to enhance stability. It will never be possible to have enough smart regulators in place that can outwit private sector participants who really want to get around regulations because they inhibit profit opportunities or because of the burdens imposed. A good regulatory environment is structured so that people who take risks stand to lose their own money if their bets do not work out. The crisis we are going through was caused by both market and regulatory failures and the market failures were often the result of a lack of transparency (“asymmetric information” in the jargon of economics). Those who invested money and lost it often did not realize the risks they were taking. To the extent that policymakers can enhance transparency, they can make market forces work better and help achieve the goal of greater stability.

Having a single micro prudential regulator would help greatly in meeting the objectives of regulation, a point that will be taken up in more detail below. It is not a new idea. In 1993-94, the Clinton and Riegle proposals for financial regulation said that a single micro prudential regulator would provide the best protection for the economy and for the industry. In the Blueprint developed by the Paulson Treasury, it was proposed that there be a single micro prudential regulator. 

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After 10 hectic days, Cypriots will return to economic life. The price, however, is an inevitable and costly adjustment plan. But contrary to many predictions, the eurozone and the Cypriot government have been able to find a solution in less than 10 days. Moreover, the eurozone has avoided yet another financial hurdle that, despite its small size, was described as having the potential to start another acute phase of the euro crisis.

The management of the eurozone crisis over the last three years has proven to be extremely tortuous. It remains so, and this episode will certainly not be the last. However, observers might also point to how the management by congressional leaders of the U.S. fiscal and deficit problems reveals similar political complexities. Could both be the inevitable result of a democratic, diverse, continental political constituency?

What people need to understand about the eurozone is its continuous willingness to ensure the future of the euro, and its (until now) proven capacity to find compromises despite diverging national interests.

Cyprus has been recognized for months as a ticking bomb within the eurozone, mixing a hypertrophied banking system (that produced jobs and wealth for Cypriots) with huge Russian deposits and suspected money laundering.

Cyprus has been recognized for months as a ticking bomb within the eurozone, mixing a hypertrophied banking system (that produced jobs and wealth for Cypriots) with huge Russian deposits and suspected money laundering. It seems that this had become Cyprus’s most important comparative advantage. The fight against money laundering is supposed to be a great cause of the OECD countries, and it is surprising to note that this aspect did not receive appropriate weight when commenting on the unconventional tools used by the troika to design its plan. The Cypriot banking system is not like the average banking system of Southern Europe. It is a case in itself and deserves a solution of its own.

The “success story” of Cyprus was destroyed by the haircut on Greek bonds; Cypriot banks hold massive amounts of Greek bonds on behalf of their foreign clients. Incidentally, this says a lot about the prowess of this supposed “international financial center” and the awareness of its clients. For many reasons, mostly the country’s democratic process, the active search for a solution to problems in Cyprus had been postponed for months until Saturday, March 16, when an agreement was reached between the newly-elected president of Cyprus, the eurozone governments, and the troika. On that date, every old prejudice about the mismanagement of the eurozone crisis, that had been shelved for the last year, suddenly resurfaced with a new torrent: of criticisms (an ill-conceived plan); of denunciations (a crisis of stupidity); of rejection (Europe is for people, not for Germany); of financial horrors (inevitable propagation of the Cypriot bank run); and finally of doomed forecasts (be alert, the breakup is coming).

Yet one week later, it is interesting to visit the control room and watch the radar screens:

• The agreement? Better designed and operational as of Monday, March 25; 
•  Bank runs propagation? No sign (even in the London branches of the two Cypriot banks);
• European periphery bond market? A definitely strong first quarter;
• Stock markets? Stable;
• Exchange markets? Stable.

However, we should not consider this summary to mean that this new episode in the eurozone saga has been more efficiently managed than the previous ones. Definitely not!

Two examples among many explain why this is not the case. First, the idea to tax every bank account whatever its amount was not a product of “German stupidity” but reflects a demand from the Cypriot president, who was willing to preserve the image of the island as a financial center; as if the confidence of dirty money could be a sustainable comparative advantage for Cyprus! The stupefying thing is that the other euro governments accepted this clause even though it was financially dangerous and certain to be rejected by the populace and its representatives. In following the relief produced by the substance of the new agreement, the Dutch finance minister and chairman of the Eurogroup announced that the Cypriot treatment was great news because it showed that bank depositors may be expected to contribute to future bailout packages. However this is explosive and potentially as damaging as the PSI initiative adopted at Deauville. There was immediate backtracking but this reminds us that the whole process remains fragile. All this being properly considered, we should examine the ongoing euro crisis along a different narrative.

And after having described the situation in Cyprus as potential chaos in the waiting, experts now explain the absence of collateral effects by referring to the July 2012 famous commitment of Mario Draghi.

What the above mentioned facts demonstrate is that markets and people outside of Cyprus adopted (at least until the Dutch minister’s proclamation) a much calmer view than specialized commentators. And after having described the situation in Cyprus as potential chaos in the waiting, experts now explain the absence of collateral effects by referring to the July 2012 famous commitment of Mario Draghi. This is at best an excuse for not exploring other explanations and at worst a superstition for placing too much power in his mouth. Rather, two broader facts should be emphasized:

• First, looking outside the eurozone, the euro has remained as attractive an international currency as before all the vicissitudes of the sovereign debt crisis despite all the aggressiveness on part of the international financial press. The exchange rate with the dollar constantly remained close to 1.3— a rate which reveals an over-valuation of the euro; such stability is surprising given all the daily announcements of its forthcoming collapse. This fact, which has never received proper attention, at the very least proves that the euro has always remained as attractive as the dollar. After all the drama we have gone through, there was little chance that the Cypriot episode will change this global perception of the euro.
  
  
• Second, within the eurozone, there is an underestimated willingness to stick to the euro as the currency of the European continent. Austerity measures are never popular and governments that adopt them have been punished in Greece, Spain, France and Italy. Nevertheless, this is the natural product of democracy, and when it comes to the explicit question— “do you prefer to stay in the eurozone, with its mechanisms and constraints, or move on your own?”— the popular answer everywhere has been “we stay”. This is what popular votes have proven in Ireland, Greece and Spain, as well as in Germany where local elections have regularly promoted euro-friendly candidates.

So what can we conclude from the recent crisis in Cyprus? The first conclusion is that Cyprus will pay a high price for exiting a dramatic situation and securing access to eurozone support; no other feasible deal was better than that one at that particular moment. Second, we have witnessed once again the willingness of the eurozone to stay the course, and its ability to design imperfect but feasible compromises, which is not so bad when compared to what’s going on in Washington. In brief, this is another Euro-solution. However, Cyprus is certainly not the last challenge confronting the governments and people of the eurozone. In that sense, the most problematic lesson from this chaotic week is not financial but political. The future of Europe more and more lies in the hands of Germany and there is no place here for accusing the Germans of egoism. Financially speaking, they have moved forward at every step during the last three years and they are the ones that repeatedly take the biggest risks. There is no question that Germany has a prominent voice and that it defends its financial security before entering into an agreement. This is what should have been expected and this is what we have seen with what happened in Cyprus. Looking forward, the bigger problem facing the eurozone is the urgent need to design a macroeconomic policy that will spur a return to growth for the region. On this issue, there is still no visible Euro-solution and that could prove to be the biggest risk facing Europe.