The future of financial regulation will be a crucial issue in many countries as the financial sector becomes more complex. This article explores the potential for different regulatory approaches in the wake of Basel II and what these could mean for the economy.
Traditional on balance sheet credit intermediation
Traditional on balance sheet credit intermediation is one of the hottest topics in financial regulation today. One reason is the sheer size of the nonbank banking industry. Nonbanks are a significant contributor to systemic risk. In the United States, lending by these entities is growing. However, if you’re looking to implement sound regulatory policies, you’ll need to be aware of the complexities involved.
This is not to say that nonbanks are a shoo-in for all-important regulatory scrutiny. The FSB has defined a narrower version of the credit intermediation metric, and it’s certainly true that there is more to the shadow banking world than meets the eye. Among other things, a narrow definition of shadow banking will help policymakers in the future to better track systemic risks in their respective countries.
During the financial crisis, many legislators were faced with the challenge of how to deal with the failure of large financial firms. While there was no shortage of bailouts, the government did not seem to have a clear solution to the too-big-to-fail problem.
Congress saw a need for a more formal process to liquidate large complex financial firms. Eventually, the Dodd-Frank Act was enacted to give financial system supervisors a new tool. Among the many provisions, Dodd-Frank included an orderly liquidation authority, or OLA.
The Orderly Liquidation Authority is an official government process that allows the Federal Deposit Insurance Corporation to handle the liquidation of an entire firm, rather than just a single subsidiary. This has the potential to make the process of liquidating distressed financial firms much safer.
Bank capital regulation may amplify business cycles
The current financial crisis has revealed a lack of capital buffers within banking institutions. This has led to the call by the International Monetary Fund (IMF) for a global action plan to mitigate procyclicality. It has also prompted the Financial Stability Board to review bank capital regulations.
Bank capital requirements are designed to protect banks against the costs of unforeseen losses. While they do provide a cushion, they do not completely remove the risks associated with borrowing from the bank. These risks include interest rate risk and credit risk. In a recession, these risks tend to increase.
Banks’ capital requirements are usually based on their portfolios’ risk. Risk weights are derived from the mean probability of default over the business cycle. When banks have less capital, they delay their response to interest rate shocks. During bad times, they tend to decrease lending.
Basel II’s transparent framework could be complemented with countercyclical overlays
Basel II is a regulatory framework designed to enhance the quality and quantity of capital in the financial sector. It was introduced in response to the global financial crisis of 2007/2008. It aims to reduce the scope for regulatory arbitrage. The regulations establish risk management requirements and establish capital management procedures. They also aim to safeguard overall economic stability.
Basel II applies to originators of securitisations and sponsors of market risk. The regulations set out a three-pillar system to calculate regulatory capital requirements. Each pillar is designed to address a specific risk. For example, the first pillar focuses on the measurement of credit risk. In addition, it includes a standardized operational risk framework.
The second pillar aims to mitigate risks of losses to creditors. It requires a buffer of unencumbered high-quality liquid assets. This buffer must be large enough to cover the institution’s net liquidity outflows during a stress scenario.
Financial regulation has changed a lot over the years. The Netherlands was a pioneer in the field in the early modern era. Today, the financial industry is a complex concoction of laws, regulations, and incentives. Some firms, like Goldman Sachs and Fortress, are subject to the same regulation that governs public firms.
While no one can claim to be an expert in the field, one can make a case for a unified financial regulatory framework for the U.S. Depending on how one defines “financial regulatory framework,” this may include a variety of measures, from the oversight of the Federal Reserve to the creation of a centralized agency responsible for consumer protection.
In addition, the most important component of a financial regulatory framework may be the ability to enact reforms that can help mitigate the effects of the global financial crisis. It also might be worth examining the role of the Fed in fostering innovation and ensuring that the financial sector has a fair shot at succeeding in the future.