Abstract
This article considers the lessons from the global financial crisis for redesigning the financial system and its regulation to make the chance of future such crises lower. It focuses on three areas: improvements to the regulation of individual financial firms; macroprudential analysis and improving the structure of crisis resolution and management. It argues that if the authorities implement a credible crisis management regime where no firm is too big to be resolved, a smarter and more incentive based approach to the regulation of individual financial firms and extensive macroprudential analysis that both makes the structure of financial markets less risky and identifies risks, the risk of future crises will be reduced. But no framework can eliminate the risk altogether.
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Notes
However, the existence of so many failures may have been due to inadequate recognition of problems earlier by the FDIC. As Garcia (2010) points out, several of the Material Loss Reviews that are undertaken after such failures are pointing to many errors—almost all of them failures to act on the familiar indicators of problems, such as concentrated lending.
Responsibility for prudential supervision in the UK is set to switch from the FSA to the Bank of England following the change in government but this will not affect the nature of the SRR.
A bridge bank is a temporary company set up by the Bank of England and registered by the FSA that manages all or some of the assets and liabilities of the failing bank until such time as the entity can be sold back to the private sector. It provides an opportunity to continue to operate all or part of the institution where continuing as a going concern is thought to be less costly than closure. It implies that the losses of the bank will not exceed the claims on the FSCS and so only temporary financing by the Bank of England is required. If the problems are more serious and the bank needs to be saved, then outright public ownership will be required and the bank nationalized but this is a last resort. An important distinction between a bridge bank and nationalization, spelt out by Brierley (2009), is that in the case of a bridge bank the Bank of England acquires control for a temporary period until sale to the private sector (or insolvency) it does not acquire the economic rights and on sale these are assigned to the shareholders and creditors following the normal priorities.
The main reason for mentioning this is that it may be more difficult to think out how to handle cross-border banks if the objectives of the individual countries involved are multiple and involve a different ranking of factors.
The latest version of the proposals for ‘Basel 3’ (26 July 2010 available from www.bis.org) also includes a cyclical buffer, an issue that is dealt with in Sect. 3.1.
See also Brunnermeier et al. (2009, p. 10).
The directors of the Dunfermline Building Society complained that this was the case when the SRR was used in the UK (House of Commons 2009).
To be more literal the requirement is that the degree of establishment of the liability can be sufficiently accurate that the deposit insurer can cope with the problems of over-payment. (It is very difficult to claw back payments that have been made in error even if the legal requirement for their repayment is clear).
It is not simply that a macroprudential approach deals with the system as a whole but that simply in dealing with individual institutions it is necessary to consider the impact of their actions on the rest of the system as well (Morris and Shin 2008).
This same problem applies to the counter-cycle measures suggested in Sect. 3.1 on procyclicality (Basel Committee 2010). If action in periods of ‘excess growth’ someone has to decide when an excess exists and the typical problem that leads to a crisis is the plausible explanation of why faster growth should permissible on this occasion—the explanation of the new economy was used in the case of the dotcom boom round the start of the century.
The leverage ratio and liquidity requirements provide restrictions on the composition of assets and not just on the minimum capital cover (Morris and Shin 2008). When a financial institution is highly leveraged, small changes in market conditions, such as an increase in haircuts imposed on collateral, will have a massive effect on their asset position, requiring a major contraction. With lower leverage the shock may require little change in behaviour. Banks looking purely to their own concerns are likely to hold too little liquidity and hence take on excess systemic risk because they do not consider fully the implications of their actions for others and the actions of other similarly placed banks on them in the face of an adverse shock (Korinek 2008).
The literature tends to focus on financial asset prices in the discussion of procyclicality but property prices may be even more important (Mayes and Virén 2008). Property is an important source of collateral and the asset that underlies large portions of bank and non-bank lending—a factor that was particularly obvious in the present crisis (Brunnermeier et al. 2009).
This is discussed in the next section.
Sheppard (2009) suggests that before following an agent’s recommendation one should find out what proportion of their own wealth they hold in that asset.
Korinek (2008) points out that if the extent of liquidity support is fully anticipated then there is a danger that it will not be effective.
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I am grateful to Franz Hahn and conference participants for helpful comments. The original version of this paper was presented as a keynote address at the conference ‘The Aftermath of the Financial Crisis’ in honour of Kurt W Rothschild at the Austrian National Bank on 6 November 2009.
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Mayes, D.G. The future of financial markets: financial crisis avoidance. Empirica 38, 77–101 (2011). https://doi.org/10.1007/s10663-010-9141-4
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DOI: https://doi.org/10.1007/s10663-010-9141-4