Financial Regulation in a System Context

TLDR

The global financial crisis exposed limitations of capital requirements, which have long been central to bank regulation but fail to distinguish asset risk from systemic importance. The study proposes that liquidity requirements limiting asset composition, together with a maximum leverage ratio, could complement capital rules by focusing on systemic stability. The authors advocate a maximum leverage ratio, justified by its role in stabilizing liabilities within an interrelated financial system rather than merely buffering asset losses. The Bear Stearns collapse in March 2008 demonstrated that meeting capital requirements alone does not prevent bank failure.

Abstract

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.