23 January 2012

Nicolas Véron: Financial reform after the crisis - an early assessment

This latest paper from Bruegel takes stock of global efforts towards financial reform since the start of the financial crisis in 2007-08, and provides a synthetic (if simplified) picture of their status as of January 2012.

One of the key lessons of the crisis is the close interdependence between the detailed features of financial systems and macro-economic outcomes. Thus, the tight separation of financial and macro-economic issues, which is entrenched both in academia and in the policymaking community, needs to be overcome. Initiatives better to analyse 'macro-financial' linkages and to conduct 'macro-prudential' policy have mushroomed since the start of the crisis, although they generally fall short of a fully joined-up framework. From this perspective, the focus of this chapter is financial regulation in an old-fashioned sense, understood as a cluster of interrelated policies designed to ensure the proper functioning and integrity of financial systems. This scope includes public regulation and supervision of bank capital, leverage, liquidity, and risk management; control of moral hazard and financial industry incentives; protection of the customers of financial services; and the regulation of capital markets. Other reform areas such as capital-flow controls, prevention of money laundering, and the taxation of financial activities can overlap with this agenda, but are not considered here part of it in a strict sense.

The general impetus of financial reform as a reaction to the crisis, in the US and Europe, has been towards more regulation, or re-regulation. This is admittedly too simplistic a generalisation: this policy area is multidimensional and cannot be reduced to a simple choice between less or more regulation. Nevertheless, there was a clear turning point in 2008 with the renewed realisation that financial systems, including banking systems, could not be left to their own devices, both because of the large potential economic cost of financial crises and because public expenditure is often a key component of their resolution. This age old wisdom was neglected in the preceding decade in both the US and Europe, for different reasons, more than in the rest of the world, including Australia, Canada, Japan and emerging economies.

Financial regulation is a complex thicket of highly technical policy challenges, often subject to the use of mutually incomprehensible jargons even as they are mutually interrelated. The devil is generally in the details, and elegant quantitative modeling of policy trade-offs is rarely available. Analytical frameworks tend to be similarly fragmented across different academic silos, including economics, financial research, accounting, political science, and sociology. From an economic research perspective, this is a less mature field than other policy areas such as fiscal, trade or labour policies. Hopefully, the crisis itself will result in new avenues for research, the results of which might start to become available in a few years’ time.

In this working paper, underlying dynamics are described and analysed both at the global level (particularly G20, International Monetary Fund and the Financial Stability Board) and in individual jurisdictions, together with the impact the crisis has had on them. The possible next steps of financial reform are then reviewed along several dimensions, including ongoing crisis management in Europe, the new emphasis on macro-prudential approaches, the challenges posed by globally integrated financial firms, the implementation of harmonised global standards and the links between financial systems and growth.

Working Paper 2012/01

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