Banking reform: What has to be done?

By Don Alexander, MBA,
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

The recent financial overhang in Europe crisis has revealed the vulnerabilities of the Eurozone financial sector and the critical role the sector plays in the real economy. It also made it clear that the banking system needs fixing.

This is a question Wouter den Haan, asks in a recent VOXEU communique Nov. 30^th called Banking Reform: Do we know what has to be done? The question is what reforms should be implemented? It is critical that much better legislation be both discussed and implemented to properly regulate the financial sector.

Better regulation is important for reducing the chances of another major financial crisis, but better regulation may also be an essential factor in re-establishing confidence in the financial sector itself. Indeed, it is thought that such confidence may be an essential ingredient for a healthy economic recovery.

Even before the crisis, it was well known that our financial system was exposed to some key risks. Despite this wisdom, the risks were clearly underestimated and the mechanisms to prevent severe disruptions were clearly not in place. Now we are designing new legislation, it is important that we understand what went wrong.

During the postwar period, there had been numerous innovations in the financial sector and there were plausible reasons to believe that these innovations would stabilize the system. Securities rapidly became more complex. Financial regulators, rating agencies and risk managers did not have the resources and expertise to deal with this increased complexity.

It was assumed that a new set of rules would not only fix known problems, but any new ones that may arise. The financial system is dynamic and as new vulnerabilities appear, financial institutions will try to find ways around legislation. So the new regulatory system should be flexible enough to deal with a changing world and it also should be such that complacency cannot put our economy at risk again. Recent research indicates that countries exposed to a financial crisis do not reduce a country's probability of being hit by another financial crisis. The explanation may be due to the inability of regulators to keep up with the dynamic evolution of modern banking.

There is a need for better funded oversight and better in-depth knowledge among financial regulators and academics about what is actually going on in the financial sector. The likelihood of risk reduction will also require a change of culture in the financial sector itself. The decisions made by individuals working in financial institutions ought to be in line with the long-run growth and stability of the overall institution and the overall economy, not any one individual’s short-term prospects.

A number of questions remain on financial reform:

·       Has enough been done to reduce the chance of another financial crisis?

·       Are governments overreaching and is the new regulation going to stifle growth in the financial sector?

·       Will the higher capital adequacy requirements of Basel III make the system sufficiently safe? And will they make lending (much) more expensive?

·       Will the countercyclical buffers of Basel III be enough to avoid systemic downward spirals?

·       Are the new liquidity requirements going to avoid contagion in the interbank market?

·       What kind of institutional change in the markets for derivative trading will take care of counter-party risk? How can we tackle the possibility of institutions falling like dominos, and by doing so solve the ‘too connected to fail’ problem?

·       What kind of division should there be between traditional commercial banking and other activities? Is it enough to implement limits to proprietary trading, that is, trading of financial assets with the institutions own money? Or should there be a stricter separation between commercial and investment banking activities?

·       Can or should regulation be (somewhat) different across countries? And will countries with stricter regulation face capital flight?

www.voxeu.org/article/banking-reform-do-we-know-what-has-to-be-done?