Financial Regulation in a System Context

Financial Regulation in a System Context

The global financial crisis raises questions about the proper objectives of financial regulation and how best to meet them. Traditionally, capital requirements have been the cornerstone of bank regulation. However, the run on the investment bank Bear Stearns in March 2008 led to its demise even though Bear Stearns met the letter of its regulatory capital requirements. The risk-based capital requirements that underpin the Basel approach to bank regulation fail to distinguish between the inherent riskiness of an asset and its systemic importance. Liquidity requirements that constrain the composition of assets may be a necessary complement. A maximum leverage ratio—an idea that has gained favor in the United States and more recently in Switzerland— may also prove beneficial, deriving its rationale not from the traditional view that capital is a buffer against losses on assets, but rather from the importance of stabilizing liabilities in an interrelated financial system.

Stephen Morris and Hyun Song Shin

Brookings Institution

Fall 2008

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