Counter Cyclical Financial Regulation: Potential for Engendering Greater Stability in the Financial System

Financial Crises can be shown to be related to the pro-cyclical nature of finance. In fact, the bigger financial crises are almost always preceded by a credit market or an asset market boom. And the recurrence of crises time and again suggests that financial regulation as it exists today has been ineffectual in preventing them. This paper explores the role that Counter-cyclical Financial Regulation could potentially play in the bringing about greater stability in the financial system by moderating the boom, so as to mitigate the bust. It considers the anatomy of a typical crisis using Minsky's Financial Instability Hypothesis, and tries to identify the general factors that trigger crises that regulation could address. Counter-cyclical regulation leans against the build-up of a credit bubble, and makes provisions when times are good for when the bubble burst and things turn awry. The paper builds a heuristic model to demonstrate how such regulation can impede the growth of a bubble. The paper also discusses the political economy associated with counter-cyclical regulation. Despite the limited experience with such regulation and the potentially adverse impact on output growth, counter-cyclical financial regulation has great potential for preventing financial crises.