Sound At Last? Assessing a Decade of Financial Regulation
This first report in a new series from IESE Business School and CEPR on ‘The Future of Banking’ tackles three important areas of post-crisis regulatory reform: the Basel III agreement on capital, liquidity and leverage requirements; resolution procedures to end ‘too big to fail’; and the expanded role of central banks with a financial stability remit.
What has changed since the 2007-2009 crisis to ensure that the financial system The Future of Banking is sound at last? Is regulatory reform going in the right direction? Has it run its course? This report tackles three important areas of post-crisis regulatory reform: the Basel III agreement on capital, liquidity and leverage requirements; resolution procedures to end ‘too big to fail’; and the expanded role of central banks with a financial stability remit. The report starts by noting that narrow banking will not overcome the fragility of the system; if it were to be implemented, fragility would resurface elsewhere in the financial system.
While there have been improvements in financial regulation and supervision during the decade since the global financial crisis, there is still much to be done:
- Prudential regulation should take a holistic approach, setting requirements for capital, liquidity and disclosure together and taking account of the competitive conditions of the industry. This approach casts doubt on the need for two liquidity ratios as currently envisaged.
- Stress tests are very useful if well designed – they must be severe, flexible and not overly transparent. However, effective stress tests can only be implemented when there is a backstop for the banking system, as the case of the euro area shows.
- To ensure that an ever-changing financial system remains resilient, authorities need a framework to monitor, assess, designate, regulate and supervise entities outside the perimeter of regulation. This applies to shadow banking and new digital competitors.
- Resolution needs liquidity support but current procedures are lacking, particularly in the euro area. The report points at the difficulties of implementing the ‘single point of entry’ model of resolution.
- Central banks have to recover their traditional financial stability remit, and these more powerful central banks need strengthened accountability and democratic legitimacy. The authors tend to favour endowing the central bank with macroprudential authority, along with the appropriate tools. More intensive coordination between monetary and fiscal authorities is needed, particularly when the zero lower bound for interest rates is reached.