Page 18

financing, the GSEs eventually held

an emphasis on increased consolidation

sheets and transferring those risks to the

over half of the AAA-rated tranches

and accountability.

institutions and individuals most able to

These

bear them. However, the entities within

are just a few of the myriad failures of

the shadow banking system are highly

government regulation that precipitated

leveraged and are largely funded through

the recent crisis.

short-term capital markets, while their

assets

of

subprime

securitizations.

Confronted with these failures,

are

typically

long-term

and

there is understandably a desire to find

illiquid. Furthermore, because they are

someone or something in particular to

not depository institutions, these entities

blame—whether greed

or

is

private-sector

lack federally insured customer deposits

government

incompetence.

and are unable to access the support of

it

the central bank in its role as lender of

Still, if the last two years have taught us anything, it is that the subprime

Regardless of the actual agencies

last resort. This combination of factors

crisis really was a systemic breakdown

involved, any regulatory regime should

makes these institutions particularly

of epic proportions. In short, it took all

focus on three core objectives: micro-

susceptible to even minor disruptions

of us working together to mess things

prudential

in

up this badly. With that in mind, it is

institutions; macro-prudential regula-

entities operate almost entirely outside

important to take a broad approach

tion, which helps guard against systemic

of the existing regulatory umbrella.

to banking regulation going forward,

risk; and consumer protection. While the

Thus, regulators must find some way

addressing the wide array of threats

government certainly failed in all three

to establish appropriate capital and

to systemic stability. This necessitates

areas, macro-prudential regulation is

liquidity requirements, while at the same

truly

arguably most important going forward.

time providing mechanisms to support

Recent

that

and potentially shut down these firms

monitoring the safety and soundness

in times of crisis. Still, regulators must

fundamental

structural

and

policy changes.

regulation

experience

of

has

individual

shown

Structural Changes

of individual banks is not sufficient to

While the economy of the United States

guard against systemic risk, especially

has long been the envy of the world,

given the global and interconnected

the same cannot be said about our

nature of the modern financial system.

regulatory structure. The sharing of

Instead,

regulatory authority across the Federal

against growing risks in the system as

Reserve, Treasury Department, and an

a whole, focusing on increases in overall

“alphabet soup” of regulatory agencies

leverage and the deterioration of lending

has led to substantial overlap, as well

standards. This will necessitate more

as gaping holes, in regulation. As the

regular and stringent scenario analyses

pace of financial innovation continues

and stress tests, which can account for

to quicken, there is an overriding

correlations between institutions and

need for f lexibility and accountability

asset classes, while at the same time

on the part of regulators, a need that

explicitly

has been completely unmet by our

worst-case scenarios.

fragmented

regulatory

structure.

regulators

evaluating

must

the

credit

markets;

however,

these

protect

impact

of

Finally, the regulatory framework

remain vigilant. The current shadow

Currently, large financial institutions

must

loopholes

banking system was largely a product of

face

which

closed—to account for the rising “shadow

regulatory arbitrage, and it is possible

encourages regulatory arbitrage. They

banking” system, including investment

that a new set of firms will emerge in

are also regulated on the basis of their

banks, hedge funds, SIVs, monoline

response to upcoming regulations. This,

sometimes arbitrary legal forms instead

insurers, and others. In theory, the

along with international competition,

of their true business function. This

shadow banking system has the benefit of

should put an upper bound on possible

structure clearly needs to change, with

getting certain risks off of banks’ balance

regulations going forward.

18

multiple

regulators,

S PRIN G 2 0 1 0

be

expanded—and

International Business Review - Spring 2010  

The Spring 2010 edition of the IBR.

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