Deregulation was one of the root causes of the eurozone crisis. New and largely unregulated financial instruments such as derivatives allowed banks in the core eurozone countries to pump up their financial leverage. As a consequence, these banks were able to lend more money more cheaply.

This had a domino effect. Large flows of capital from core eurozone countries into the periphery contributed to the housing and consumption booms in Portugal, Ireland, Italy, Greece, and Spain.

Policymakers responded to the crisis by tightening regulation. The EU moved resolutely from “light-touch regulation” to a more interventionist approach. The challenge now is to engage both the public and the private sector to ensure the right level of financial regulation.

Europe’s crisis-era regulatory reform package is almost complete, following agreement last June on the Capital Requirements Directive IV package. This legal framework introduces new standards on capital for banks, building societies, and investment firms, as well as new corporate governance rules.

Financial institutions are concerned about the cost of implementing this legislation. They also fear that the new regime could stifle innovation. As a consequence, the EU’s brand-new postcrisis regulatory framework is already undergoing review.

The swing in the regulatory pendulum from a minimalist attitude toward more rules, principles, and guidelines in the Western world is having perverse effects in Asia, too.

A recent Economist conference in Sydney on global financial challenges reflected a mood of caution. Speakers urged prudence against the blind implementation of regulations designed for developed countries but applied almost unchanged to less developed regions.

For instance, the U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which has been described as “the most far-reaching Wall Street reform in history,” introduced measures that apply not only to U.S. financial entities, but also to their trading partners, including those in the developing world.

This has translated into a loss of counterparties, or state institutions that can ultimately guarantee loans and indemnities, because Asian financial institutions shy away from heavy regulatory obligations.

The long-term effect of fewer counterparties is less liquidity in the markets. Art Certosimo, chief executive officer of U.S. bank BNY Mellon, told the Sydney conference that although Asian central bankers were engaging in the “spirit” of change, the “pace of change . . . is potentially dangerous.”

As in the story of “Goldilocks and the Three Bears,” the bed of regulation is either too hard or too soft. When Goldilocks finally finds the bed that is “just right” and falls asleep, she wakes to the growl of Papa Bear and runs with fright into the forest, never to be seen again.

So what regulatory approach is “just right”? And how can we ensure a happy end to the tale of regulation?

John Denton, chief executive officer of Australian law firm Corrs Chambers Westgarth and a member of Asia-Pacific Economic Cooperation, a forum for economic cooperation among Pacific Ring countries, suggested that the debate needs to broaden out.

In his view, policy discussions on regulatory restructuring are often limited to trade ministers who are not in charge of domestic economic reforms. The debate should therefore shift to finance ministers who could bring together economic integration and financial-services reform.

Justin O’Brien, director of the Center for Law, Markets, and Regulation at the University of New South Wales, has proposed a blueprint for reform in his forthcoming book, Regulating Culture: Integrity, Risk and Accountability in Capital Markets. The effectiveness of any regulatory system, he argues, necessitates a new “social contract” between the banking sector and society at global level. This in turn requires the purpose of financial regulation to be more explicit.

The former chair of the Federal Reserve, Paul Volcker, also believes that tinkering at the edges of a highly complicated regulatory system is no longer sufficient. In a speech last May, he said the problem was not simply one of financial structure and regulation but rather of the underlying economic forces, which are wholly out of kilter.

For solutions, Volcker believes in looking to the past. He has pointed to two special inquiries launched in the United States during the 1960s. Together, they reinforced the rationale for the independence of the U.S. Federal Reserve “at a time when that was not taken for granted.”

Today too, Volcker contends, only a partnership between the public and private sectors can understand the complexity and interconnections of the financial sector. More importantly, profound change cannot be imposed from the outside, but must come from within.

But what should that profound change look like?

Here, Volcker remains vague—but the “Volcker Alliance,” the octogenarian’s foundation aimed at improving how government works, is just a few months old. Ultimately, he believes, it is only through a public-private partnership that the Goldilocks principle of financial regulation can be achieved. But that partnership needs to be set on the right path.


Elaine Byrne is a senior research fellow at the Center for Law, Markets, and Regulation at the University of New South Wales.