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Issue no. 235 of the National Institute Economic Review includes articles by six renowned financial economists who each investigate one key aspect of the Global Financial Crisis (GFC) and the regulatory response:

• ‘The missed opportunity and challenge of capital regulation’ by Anat R. Admati;
• ‘Regulatory failure and regulatory change in the banking sector’ by David Miles;
• ‘Liquidity regulation: rationales, benefits and costs’ by Gianni De Nicolò;
• ‘Too big to fail and too big to save: dilemmas for banking reform’ by James R. Barth and Clas Wihlborg;
• ‘Regulatory cooperation on cross-border banking - progress and challenges after the crisis’ by Thorsten Beck;
• ‘Macroprudential supervision: from theory to policy’ by Dirk Schoenmaker and Peter Wierts.

The Review has been edited by NIESR’s Dr Angus Armstrong and Professor E Philip Davis, a Visiting Fellow at NIESR and Professor of Banking and Finance, Brunel University.

The authors, who will also present at the National Institute’s Annual Finance Conference at the Bank of England on March 18th, were asked to have in mind the following guidance:

“Since the Global Financial Crisis a number of regulatory policies have been discussed, proposed and sometimes implemented to address the shortcomings in the regulatory framework. These include capital and liquidity regulation (notably via Basel III), developments in cross-border bank resolution, macro-prudential policies and addressing the issue of too-big-to-fail. It is timely to take a critical overview of these various measures to see whether we are closer to a financial system that is both appropriately stable and efficient in fulfilling its functions to the wider economy. Could better ways to address the underlying problems be conceived? And what are the open questions?”

Anat Admati focusses on capital regulation for banks; equity holders and creditors have competing interests as the former benefit from the upside of risks while the latter share only the downside of risks. She contends that Basel III is a missed opportunity: capital requirements are still too low and she criticises the use of risk weights (especially zero weights) which offer incentives to manipulate disclosure and maximise risk. Instead she recommends a 20–30 per cent equity ratio with a transition financed by zero dividends. Meanwhile, the tax code should be amended to reduce the incentive of banks and other corporations to take on debt instead of equity.

David Miles (d.miles@imperial.ac.uk) contends that the key problem building up to the GFC was not ‘light touch regulation’ but banks operating under Basel II with very high leverage on risky assets, often as a result of low risk weights. Miles is sceptical of the need for liquidity requirements in addition to capital regulation as enough capital is usually a guarantee of liquidity. But the key point is that regulators are not requiring adequate capital ratios.

Gianni De Nicolò’s (gdenicolo@imf.org) paper on liquidity regulation highlights how a number of important externalities linked to liquidity were brought out by the GFC. The response to these has been an implementation of liquidity regulations in Basel III. Among these, the Net Stable Funding Ratio is seen as requiring changes in banks’ structural funding while also requiring adaptation by central banks in their operational frameworks, as it is likely to reduce money market volumes and increase the attractiveness of long term central bank refinancing. Generally, liquidity regulations may impose extra social costs on the economy by restricting maturity transformation. One suggestion is that ex ante prompt corrective action elements in liquidity regulation could provide appropriate financial stability protection at lower cost.

James Barth (barthjr@auburn.edu) and Clas Wihlborg (wihlborg@chapman.edu) define ‘too big to fail’ (TBTF) where a bank is seen to generate unacceptable risk to the banking system and the economy if it were to default and fail to fulfil its obligations. The problem has been growing historically as large banks continue to grow and dominate financial systems. ‘Big’ may be defined in various ways, including not only various measures of size but also complexity, whereby empirical work shows that number of subsidiaries and involvement in market based activities contribute to systemic risk. The authors note that the costs of TBTF regulation in terms of lost economies of scale or scope are rarely allowed for, nor are the risks of activities shifting to the shadow banking sector. Furthermore, they are sceptical whether the reforms underway are strong enough to allow a large bank to be resolved with uninsured creditors sharing the losses.

Thorsten Beck (Thorsten.Beck.1@city.ac.uk) highlights how cross-border banking has grown rapidly in recent decades, not only in OECD countries but also in developing countries. The need for supervisory cooperation is essential because failure of a bank in one country can give rise to substantial externalities in other countries, notably given the ongoing integration of financial systems. Significant limitations exist with existing resolution mechanisms, even in Europe with Banking Union, as the safety net has not been moved to a supranational level. In developing policies, Beck also argues that regulators need to become more aware that there is a feedback loop from changes in supervisory architecture to the decisions of cross-border banks.

In the final paper, Dirk Schoenmaker (schoenmaker@rsm.nl) and Peter Wierts (P.J.Wierts@DNB.NL) remind us that the authorities stood back and allowed imbalances to develop that led to the GFC. The consensus was that focussing monetary policy on consumer prices and supervision on individual institutions were sufficient for monetary and financial stability. Neglecting asset prices, leverage incentives, fragility to shocks and of the endogenous nature of risk in a downturn proved catastrophic. Accordingly, there has been a development of macroprudential policies, but whereas Basel III mandates a countercyclical capital buffer for banks this may be inadequate to brake a credit boom. The authors recommend a similar buffer for liquidity as well as tying remuneration packages to long term bank performance, and application of instruments cross border. They also recommend a time varying leverage ratio.

The Editors comment that there has been progress in regulation since the 2007-9 GFC. But many policies were set even before the crisis had finished let alone understood. Most authors contend that Basel III falls short of what is required in many ways: levels and quality of capital, the form of liquidity regulation, risk weights, inconsistent definitions and the nature of countercyclical buffers. Authors also highlight the political influence of banks as a barrier to reform and the differing interests of countries involved in international banking regulation. Appropriate incentives and information remain central to financial stability. A fundamental question is whether stability can be imposed by regulation or requires changes in the legal structure of opaque firms to align risks with principals’ returns.

Notes for editors:

For journalists wanting full copies of these papers, please contact the NIESR Press Office: Luca Pieri on 020 7654 1931 / l.pieri@niesr.ac.uk / press@niesr.ac.uk

The National Institute Economic Review is a quarterly journal of NIESR. Published in February, May, August and November, it is available from Sage Publications Ltd (http://ner.sagepub.com/).

The latest economic forecasts for this issue of the National Institute Economic Review are to be released on Tuesday 2 February, embargoed for 00.01 Wednesday 3 February.

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