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Much has already been done to improve financial stability and resilience of financial institutions after the crisis, particularly of those seen as too systemically important to fail. In an ideal world the externality imposed on the society by large systemically important banks might be dealt with by a single optimally designed regulatory instrument. However, in the real world subject to substantial uncertainties concerning the nature of risks and their measurement, it is better to rely on several regulatory instruments.
First, Basel III agreement which is implemented here in Europe through the capital requirement regulation and directive will strengthen banks' capital and liquidity positions. This is a major step to improve banks' resilience, but will also reduce incentives to take excessive risks across different banking operations. Basel III also tackles the too-big-to-fail problem by imposing an extra capital requirement on international, systemically important financial institutions.
Liquidity requirements which previously did not exist bring additional important resilience as liquidity typically dries up when a systemic crisis starts. Capital requirements also help maintain liquidity in the markets: when banks have higher capital buffers to absorb losses, there will be less need for fire sales of assets. Fire sales seriously undermined market liquidity during the crisis.
Second, new recovery and resolution tools have been constructed. The key instrument is to make it possible to bail-in bank debt in a crisis, in order to avoid bail-outs with taxpayer money. Moreover, the resolution authority is given great powers to restructure a bank when the point of likely to fail has been reached.
This will be a key in restoring private market discipline on banks, and thus to reduce the too-big-to-fail problem. The importance of implementing the Bank Recovery and Resolution Directive, upon which political agreement was achieved in the summer, cannot be overstated.
In Europe bank resolution (Single Resolution Mechanism, SRM) is part of the larger aim of forming a true Banking Union. The establishment of the SRM will facilitate the resolution of cross-border banks. The other element of the banking union is the Single Supervisory Mechanism in connection with the ECB.
The Banking Union project also includes a third element; the prospect of creating a common deposit insurance system. However, the first priority ought to be to harmonise the national systems, which currently vary greatly.
There are also a number of regulatory initiatives that intend to increase transparency in the financial markets. For example, accounting standards and disclosure practices are reviewed, and banks are urged to improve risk management and corporate governance practices. Supervision and regulation of derivatives markets and the shadow banking system are revised, including moves to central counterparties which will help address the contagion risks embedded in long counterparty chains in the OTC markets.