The Necessity of Financial Regulatory System Reform: Lessons for Iran

Abstract

One of the major reasons explaining the inefficiency and underdevelopment of Iran’s financial system—as well as its limited effectiveness in influencing macroeconomic variables in recent decades—may lie in the type of financial regulatory system in place. This issue has received little attention from researchers and policymakers in Iran, even though many countries have shifted their financial regulatory systems from traditional frameworks to more modern approaches such as the Twin Peaks model. Accordingly, this study seeks to explore Iran’s current situation by drawing on the experiences of successful countries and aims to answer the key question: What type of financial regulatory system should Iran adopt? In other words, which regulatory approach is best suited to enhance the effectiveness of Iran’s financial system? Findings from a covariance analysis conducted on 23 countries over the period from 1981 to 2020 indicate that changes in the financial regulatory authority’s approach (traditional, functional, integrated, and Twin Peaks) interacting with macro-financial characteristics (financial structure, interest rate repression, and generalized public trust) have, in most cases, led to changes in the performance of both the real sector (economic growth and inflation) and the financial sector (financial development and financial efficiency). The statistical results revealed the suboptimality of traditional and functional models, and confirmed the superiority of transitioning first to an integrated financial regulatory system, followed by the adoption of the Twin Peaks model. Due to the complexity of such systemic changes, it is recommended that an integrated financial regulatory system be implemented on a trial basis for a limited number of years before transitioning to the Twin Peaks model. From a broader perspective, it appears that Iran's economy is in need of a complete redesign of its socio-economic architecture.