Financial regulation

Background: pre-crash financial regulation

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 prohibiting 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, but their inadequacy was revealed by the crash of 2008 when the global banking system suffered its "most severe instability since the outbreak of World War I" . and threatened the collapse of its entire financial system. That narrowly-averted catastrophe prompted the urgent consideration of measures to remedy the deficiencies of the regulatory system. Recognition of the international character of the problem led to the inauguration of a series of G20 summits, initially to formulate measures to combat the recession of 2008 and subsequently to consider measures to reduce the danger of a future collapse of the international financial system.

Post-crash proposals

In January 2008, the British economist, Charles Goodhart, proposed that bank capital requirements should be what he terms "contra-cyclical", meaning that they should be raised in times of boom and relaxed in downturns In April 2008 the international Financial Stability Forum recommended a range of regulatory changes under the headings of: strengthened prudential oversight of capital, liquidity and risk management, enhanced transparency and valuation, changes in the roles and uses of credit ratings, and a strengthening of the authorities’ responsiveness to risks.

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The authorities' reactions

; and in a 2005 lecture, Jean-Claude Trichet, the President of the European Central Bank, argued that not all bubbles threaten financial stability, and that if policy-makers attempted to eliminate all risk from the financial system, they either fail or they would "hamper the appropriate functioning of a market economy". , and by Federal Reserve Board Governor Frederic Mishkin