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The need for regulation to safeguard its stability is beyond dispute: the question is not whether, but how we should regulate. Of course, the financial system is in constant flux, and regulation has to keep pace with it. Regulatory reform is usually triggered by a crisis – and the recent crisis is no exception. It set in motion a fundamental review and reform of financial market regulation. Work on this reform began at a global level in 2008, and it is still underway. Yet certain areas still need a lot more work. I would like to discuss two of these issues here today: the "too big to fail" problem and the shadow banking sector.
Too big to fail
he "too big to fail" problem was a key factor in the recent crisis, and it still isn't completely solved. So how can regulation help? One option would be to prevent large banks from becoming distressed in the first place. Notably, the new Basel III capital requirements are an important step in this process. But of course we can't rule out bank failures entirely, and nor should we try. The possibility of a market exit is fundamental to any market economy. What we need are mechanisms that allow even big banks to fail without destabilising the entire financial system. Only then will banks face the real threat of a market exit; only then will we eliminate their implicit state guarantee; and only then will banks have an incentive to be risk-aware in their actions. There is still a good deal left to be done, as the markets themselves acknowledge.
First, resolution mechanisms are inherently complex – especially those for big banks, which tend to operate globally. To be able to resolve a bank of this kind, we need international cooperation that is built on solid legal foundations. We have now taken some initial steps towards this goal – through the Financial Stability Board principles at an international level and the agreement to create a Single Resolution Mechanism at a European level. Even so, there is still a long road ahead of us.
Second, each bank resolution throws up the same question: who should bear the costs? When a bank is resolved, there have to be sufficient resources available to absorb losses. These resources – known as "gone concern loss absorbing capacity", or "GLAC" – should be sufficient to allow the failed bank to be resolved. In other words, GLAC should help to recapitalise viable components of the failed bank, or a bridge bank. The aim is to preserve the bank's critical functions while avoiding a government bailout or turmoil on the financial markets.
"Shadow banking" system
If we want to safeguard financial stability in future, regulators will need to set their sights beyond the banking system – to the shadow banking system. Despite the blurred and constantly shifting boundaries, we can attempt to estimate the size of the shadow banking system. The Financial Stability Board, for instance, puts the figure for assets under management in the shadow banking system at US$71 trillion. That would make the shadow banking system about half as big as the regular banking system. However, this global aggregate does not capture major regional differences.
The effects of shadow banking on financial stability are not entirely clear. On the one hand, the system undeniably fulfils an economic role: it offers alternative sources of funding to enterprises in the real economy as well as to banks, thereby adding to diversification and specialisation. In general, that enhances both the efficiency and the resilience of the financial system. On the other hand, the shadow banking system also harbours risks. If activities are shifted into shadow banking as a result of regulatory arbitrage, then the concomitant risks are shifted too – and thus sometimes moved out of reach of the regulatory access that is actually needed. Thus, the shadow banking system may well be a source of systemic risk and accordingly, it is very high up the G20 reform agenda.
Money market funds constitute one example of direct regulation of participants. US money market funds in particular bear a strong resemblance to banks. The main problem comes with money market funds which operate with constant share values, such that investor deposits have a constant value. With funds like this, losses are not distributed evenly across all investors. Instead, a "first come first served" rule applies. Therefore, a shift to money market funds which operate with variable share values is an important step in making the sector more stable – in these funds, losses are shared evenly by shareholders. Regulatory proposals in this regard have now been published in both the United States and Europe. However, these are focused on alternative measures such as capital cushions, liquidity charges and delayed withdrawal for funds with a variable valuation. These initiatives are to be welcomed, but an obligatory shift to variable share valuation would be better.