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.

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, 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 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.