13 March 2012

VoxEU: Seven principles for better banking regulation

The global crisis has raised many questions. How did regulators and supervisors miss the warning signs so spectacularly, particularly those responsible for overseeing the dangerously exposed financial system? This column provides a diagnosis of the problem and outlines what can be done about it.

The financial crisis that originated with subprime loan problems in 2007 and the burst of the real estate bubbles in the United States and other countries has uncovered severe weaknesses in the regulation and supervision of financial entities. The magnitude of the crisis, the worst since that of the 1930s, was amplified by channels in a globalised market and has thrown a spotlight on financial regulatory reform. Indeed, the failure of Lehman Brothers in September 2008 endangered the stability of the international financial system. The sovereign debt crisis, which started in 2010 with problems in Greece, Ireland, and Portugal and has recently spread to Italy and Spain, has provoked another wave of systemic problems centred on banks in the eurozone.

Why and how have regulatory mechanisms failed? Have there been new market failures? What can be learned from the crisis? Does it have specific implications for the financial architecture of the European Union and the eurozone? The answers to such questions will reveal the key issues to be taken into account when designing adequate regulation and will determine whether a radical reformulation of the regulatory framework is needed. 

Regulatory reform should be based on seven basic principles:

1. A central regulatory body (such as the central bank) should have a mandate to maintain financial stability and be in charge of macro-prudential supervision.
2. Monetary policy is not the appropriate tool with which to recapitalise banks.
3. Regulation and supervision should encompass all entities that carry out banking activities.
4. Expected losses of liabilities guaranteed by the government should be covered by a risk premium determined by the market dependent on the risk assumed by the entity. Banks under the protection of the safety net need to limit their range of activities because of market hazard.
5. Institutions that play a key role in the financial system (where the too-big-to-fail doctrine is applied) should be regulated so that they internalise the external effects of their potential bankruptcy. Regulatory standards should be uniform and accompanied by internationally coordinated supervision.
6. A fragmentary approach to financial regulation does not work. Competition policy should be coordinated also with financial regulation. It is necessary to consider together capital and liquidity needs as well as the degree of market liberalisation of the different market segments. Higher prudential requirements are needed in more competitive environments.
7. It is necessary to establish mechanisms to prevent delay of the supervisor’s intervention (regulatory forbearance) while the balance sheets of financial institutions deteriorate and capital declines.

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