Against Financial Regulation Harmonization : A Comment

This comment is on a paper by Christian Kirchner and Wulf Kaal, which proposes a variety of post-financial crisis regulatory reforms under a common theme of minimizing “regulatory arbitrage.” The comment focuses on one of their proposals, hedge fund regulation, and then picks up on the theme of regulatory arbitrage to discuss a broader reform issue regarding financial regulatory architecture. I contend that the move to regulate hedge funds is misguided because hedge funds were not a cause of the recent crisis, nor are they likely to cause a future one. Rather, the regulatory response to hedge funds can best be understood in terms of the historical pattern of hostility to short sellers. I further contend that the post-crisis emphasis on regulatory consolidation and harmonization, which is a common legislative response following a crisis, is as misguided as the regulatory focus on hedge funds. In particular, in a regime of global harmonization, regulatory error can result in heightened systemic risk, as regulatory incentives lead financial institutions worldwide to adopt similar business strategies. When such strategies fail, they do so on a global basis, and can thereby precipitate a global financial crisis. Accordingly, regulatory arbitrage, a byproduct of regulatory diversity, provides a valuable, and little appreciated, hedge against systemic failure