The long-standing policy debate about entity-based (EB) and activity-based (AB) regulation is marred by imprecision. This has obscured the different motivations for the two types of regulation. It has also made it more difficult to interpret catch phrases such as “same risk, same regulation”. And it has led to misleading inferences concerning the relationship between financial stability regulation and a level playing field.
To overcome the shortcomings and ambiguities in the current policy debate, The Bank of International Settlements proposes a framework for classifying financial stability regulation as either EB or AB. They also relate this framework to the classification of regulatory measures as either “microprudential” (MiP) or “macroprudential” (MaP). And we apply it to the regulation of banks, non-bank financial intermediaries (NBFIs) and big techs.
This framework clarifies the basics of financial stability policy. This framework defines AB regulation as constraining individual activities directly and on a standalone basis; and EB regulation as constraining a combination of activities at the entity level. The widespread adoption of EB regulation reflects the fact that leverage and liquidity transformation, which lie at the core of financial instability, involve combinations of activities.
The choice between EB and AB regulation depends on where financial instability originates. AB regulation is justified when an activity can fail even if the entities performing it do not; EB regulation is justified when the failure of entities causes that of activities. Adopting both EB and AB regulation in a belts-and-braces approach helps overcome their individual shortcomings. Finally, applying the framework to NBFIs and big techs highlights deficiencies of current approaches to achieving financial stability objectives.
Relating the EB/AB distinction to the MiP/MaP one delivers two insights. First, as regards taxonomy, all four combinations are possible. Second, contrary to a widely held view, well structured AB measures are not necessarily consistent with a level playing field.