Financial regulation

Background: pre-crash financial regulation

Governments have long been aware of the danger that a loss of confidence following the failure of one bank could lead to the failure of others, and to limit that danger they traditionally required all banks to maintain minimum reserve ratios. Following the crash of 1929 they also imposed restrictions upon the activities of the commercial banks. In the United States, for example, the Glass-Steagall Act prohibiting their participation in the activities of investment banks. In the 1980s, however, there was a general move toward "deregulation", those restrictions were dropped and reserve requirements were relaxed. There followed a period of financial innovation and substantial change in the nature of banking. The perception of a resulting increase in danger of systemic failure led, in 1988, to the publication of a set of regulatory recommendations that related a bank's required reserve ratio to the riskiness of its loans and, in 2004, to revised recommendations requiring banks to take more detailed account of the riskiness of their loans. Those recommendations were widely adopted, but their inadequacy was revealed by the crash of 2008 when the global banking system suffered its "most severe instability since the outbreak of World War I" . and threatened the collapse of its entire financial system. That narrowly-averted catastrophe prompted the urgent consideration of measures to remedy the deficiencies of the regulatory system. Recognition of the international character of the problem led to the inauguration of a series of G20 summits, initially to formulate measures to combat the recession of 2008 and subsequently to consider measures to reduce the danger of a future collapse of the international financial system.

Post-crash proposals

Micro- and macroprudential regulation

A paper by the United States Department of the Treasury makes the point that "a narrow micro-prudential concern for the solvency of individual firms, while necessary, is by itself insufficient to guard against financial instability. In fact, actions taken to preserve one or a few individual banking firms may destabilize the rest of the financial system". A Bank of England of England discussion paper goes further, explaining that microprudential policymakers might impose severe lending restrictions to guard against individual bank failures, whereas macroprudential policies would take account of the long-term damage to the banking system and to the economy that could result from the consequent credit shortages

Problems and remedies

Leverage

The Turner Review recommended raising banks' reserve ratio requirements to levels substantially above those required under Basel 2 and introducing a discretionary counter-cyclical element that would raise the required ratio during economic booms . The Warwick Commission on international financial reform was also in favour of counter-cyclical regulation but suggested that it should be rules-based to help central banks to resist political opposition to "taking away the punchbowl when the part gets going". Its purpose would be to persuade banks to put away money during a boom-at a time when they would be motivated to run down their reserves.

Risk management

The de Larosière Group of European regulators proposed that the board members of banks should be required to abandon the practice of relying upon risk models that they do not, and to make fuller use of their professional judgment.

Asset-price bubbles

Frederic Mishkin has noted that asset price bubbles that involve fluctuations in the supply of credit are far more damaging than those that do not . The "dot.com" bubble, for example did little damage because it was not credit-financed. A Bank of England discussion paper has examined the regulatory regime of dynamic provisioning recommended by the de Larosière Group - a rule-based scheme that requires banks to build up provisions against performing loans in an upturn, which can then be drawn down in a recession. It notes that the scheme did not appear to have smoothed the supply of credit, but may have made banks more resilient. A suggestion by International Fund economists that monetary policy should be used to "lean against" asset price booms was not well received by central bank leaders, but the international Warwick Commission insisted that "inflation targeting ... needs to be supplemented by some form of regulation specifically aimed at calming asset markets when they become overheated" .

Too-big-to-fail

The UK's Financial Standards Authority identified three aspects of the too-big-to-fall problem as:

• the moral hazard created if uninsured creditors of large banks believe that a systemically important bank will always be rescued, removing the incentive to impose discipline and prompting them to reduce their interest rates;
• the costs of rescue operation and the unfairness of the "socialisation of losses"; and
• the possibility that rescue might cost more than the host country could afford.

The US Treasury, in a paper published in September 2009, suggested that "systemically important firms" should be subject to higher capital requirements than other firms , and a G20 finance summit made the same suggestion.

Regulatory structure

The Warwick Commission argued that "macro and micro-prudential regulation require different skills and institutional tructures, and suggested that where possible, micro-prudential regulation should be carried out by a specialised agency (and that) macro-prudential regulation should be carried out ....in conjunction with the monetary authorities, as they are already heavily involved in monitoring the macro economy"