Financial regulation

 (The former text of this renamed article has been temporarily transferred to my sandbox to facilitate restructuring
Nick Gardner 16:22, 15 January 2010 (UTC))

Background

Following the financial crash of 2008, new measures have been put forward to remedy deficiencies in the existing methods of regulating national financial institutions, and there have been international negotiations concerning the coordination of such measures. The necessity has been agreed of both strengthening the "microprudential" measures that are concerned with the stability of individual financial institutions, and introducing new "macroprudential" measures that are concerned with the stability of the financial system as a whole. A paper by the United States Department of the Treasury makes the point that "a narrow micro-prudential concern for the solvency of individual firms, while necessary, is by itself insufficient to guard against financial instability. In fact, actions taken to preserve one or a few individual banking firms may destabilize the rest of the financial system". A Bank of England of England discussion paper goes further, explaining that microprudential policymakers might impose severe lending restrictions to guard against individual bank failures, whereas macroprudential policies would take account of the long-term damage to the banking system and to the economy that could result from the consequent credit shortages

Microprudential policy

Pre-crash policies

Governments have long been aware of the danger that a loss of confidence following the failure of one bank could lead to the failure of others, and to limit that danger they traditionally required all banks to maintain minimum reserve ratios. Following the crash of 1929 they also imposed restrictions upon the activities of the commercial banks. In the United States, for example, the Glass-Steagall Act of 1934 prohibited their participation in the activities of investment banks. In the 1980s, however, there was a general move toward "deregulation", those restrictions were dropped and reserve requirements were relaxed. There followed a period of financial innovation and substantial change in the nature of banking. The perception of a resulting increase in danger of systemic failure led, in 1988, to the publication of a set of regulatory recommendations that related a bank's required reserve ratio to the riskiness of its loans and, in 2004, to revised recommendations requiring banks to take more detailed account of the riskiness of their loans. Those recommendations were widely adopted.

(For accounts of the historical development of financial regulation, see paragraph 4 of the article on banking and paragraph 5 of the article on financial economics)

Post-crash proposals

Leverage

The Turner Review recommended raising banks' reserve ratio requirements to levels substantially above those required under Basel 2 and introducing a discretionary counter-cyclical element that would raise the required ratio during economic booms . The Warwick Commission on international financial reform was also in favour of counter-cyclical regulation but suggested that it should be rules-based to help central banks to resist political opposition to "taking away the punchbowl when the part gets going". Its purpose would be to persuade banks to put away money during a boom-at a time when they would be motivated to run down their reserves.

Risk management

The de Larosière Group of European regulators proposed that the board members of banks should be required to abandon the practice of relying upon risk models that they do not understand, and to make fuller use of their professional judgment. .

New risk management standards were issued by the Basel Committee on Banking Supervision in September 2008.

Derivatives

The rôle of financial derivatives in the crash of 2008 is a topic of controversy among economists. Professor Hyun Song Shin has argued that their use had undermined the stability of the financial system by concentrated risks in the banking system , and the eminent economist Joseph Stiglitz has sugqested that major banks should not be allowed to hold derivatives, especially credit default swaps, but Professor Myron Scholes has described proposals to ban them as "a luddite response". The regulatory authorities do not appear to be considering a ban on their use, but they are formulating measures to improve their ability to monitor them. The United States Department of the Treasury has proposed legislation to require clearing of all standardized over-the-counter derivatives through regulated central counterparties who must impose robust margin requirements and risk controls , and similar measures are considered in a European Commission consultation paper on possible derivatives legislation that may be expected to be discussed in forthcoming meetings of an international regulators forum

Off-balance-sheet vehicles

The international Financial Stability Board has issued new disclosure standards for off-balance sheet vehicles, and has recommended the imposition of higher capital requirements where appropriate.

Macroprudential proposals

Asset-price bubbles

Frederic Mishkin has noted that asset price bubbles that involve fluctuations in the supply of credit are far more damaging than those that do not . The "dot.com" bubble, for example did little damage because it was not credit-financed. A Bank of England discussion paper has examined the regulatory regime of dynamic provisioning recommended by the de Larosière Group - a rule-based scheme that requires banks to build up provisions against performing loans in an upturn, which can then be drawn down in a recession. It notes that the scheme did not appear to have smoothed the supply of credit, but may have made banks more resilient. A suggestion by International Fund economists that monetary policy should be used to "lean against" asset price booms was not well received by central bank leaders, but the international Warwick Commission insisted that "inflation targeting ... needs to be supplemented by some form of regulation specifically aimed at calming asset markets when they become overheated" . The possibility of using fiscal policy is also under consideration. In response to a G20 request, the International Monetary Fund has agreed to investigate the feasibility of discouraging speculation by means of a global transactions tax