Financial regulation

The purpose of 'macroprudential financial policy' is to preserve the integrity of the financial system in view of the threat to its existence posed by the crash of 2008. This article summarises the measures taken, agreed and under discussion as at November 2009.

For definitions of the terms shown in italics, see the glossary on the related articles subpage

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.

(For an account of the historical development of financial regulation, see paragraph 5 of the article on financial economics)

Post-crash proposals

Micro- and macroprudential regulation

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

Problems and remedies

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. .

The Financial Stability Board has issued new risk management standards covering bank governance, the management of liquidity risk, underwriting and concentration risks, stress testing, valuation practices and exposures to off-balance sheet activities.

Off-balance-sheet vehicles

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

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" .

Too-big-to-fail

The UK's Financial Standards Authority identified three aspects of the too-big-to-fall problem as:

• the moral hazard created if uninsured creditors of large banks believe that a systemically important bank will always be rescued, removing the incentive to impose discipline and prompting them to reduce their interest rates;
• the costs of rescue operation and the unfairness of the "socialisation of losses"; and
• the possibility that rescue might cost more than the host country could afford.

The US Treasury, in a paper published in September 2009, suggested that "systemically important firms" should be subject to higher capital requirements than other firms , and a G20 finance summit made the same suggestion. A survey-based analysis of the factors affecting organisation's systemic importance was published by a group of international organisations in October 2009 .

Remuneration and incentives

The Financial Stability Board's "Principles for Sound Compensation Practices" require that pay levels should take account of the risks - past and prospective that reipient takes on behalf of the firm - and not just their short-term profit contributions - and should be monitored and reviewed by boards of governors. Those principles have been integrated into the Basel Committee's capital framework, and international guidance is under development to reinforce their implementation. The statement of principles by the Committee of European Bank Supervisors, requires the remuneration should be based upon a risk-adjusted combination of the individual's performance and the performance of the unit to which he belongs, and that bonuses should have a deferred component related to longer-term performance.

Credit ratings

In response to the shortcomings in the conduct of the credit rating agencies revealed by the subprime mortgage crisis, the International Organisation of Securities Commissions (IOSCO) issued a revised code of conduct for credit rating agencies in May 2008 , which are designed to raise the quality of their ratins, and which contains clauses intended to "manage and mitigate" the conflict of interest that arises from the fact that the agencies receive revenue from the organisations on whose securities they issue ratings. New legislation creating oversight regimes for credit rating agencies has been approved in Japan and is close to final approval in the European Union; in the United States, amendments to the existing oversight regime have been proposed or already made (as at September 2009).

Accounting Standards

The G20 Leaders have recommended that the two international accountancy standards boards should "make significant progress towards a single set of high quality global accounting standards", and the Financial Stability Board has urged them to incorporate a broader range of available credit information than existing provisioning requirements, so as to recognise credit losses in loan portfolios at an earlier stage.

Regulatory structures

Four types of existing regulatory structure have been identified[1]:

• The institutional approach, in which a firm’s legal status determines which regulator is tasked with overseeing its activity;
• The functional approach, in which supervisory oversight is determined by the business that is being transacted by the entity so that each type of business activity has its own regulator;
• The integrated approach, in which a single universal regulator conducts both safety and soundness oversight and conduct-of-business regulation for all the sectors of financial services business; and,
• The twin peaks approach, in which one regulator performs safety and soundness supervision function and the other focuses on conduct-of-business regulation.

The "G30 report" by an eminent international consultative group stressed the need for regulatory systems with "clearer boundaries between those institutions and financial activities that require substantial formal prudential regulation for reasons of financial stability and those that do not". An earlier report by the same international group had concluded that none of the four categories of regulatory structure then in use appeared to offer a significant advantage over the others, and had attributed greater importance to the calibre of their managements. The Warwick Commission argued that "macro and micro-prudential regulation require different skills and institutional tructures, and suggested that where possible, micro-prudential regulation should be carried out by a specialised agency (and that) macro-prudential regulation should be carried out ....in conjunction with the monetary authorities, as they are already heavily involved in monitoring the macro economy", and the de Larosière Group also stressed the importance of coordination between regulators and central banks.