Financial regulation

Background: financial regulation

Central bank supervision

Governments have long been aware of the danger that a loss of confidence following the failure of one bank could lead to the failure of others, and eventually to "systemic failure" of the entire financial system. To limit that danger, they have traditionally required banks to limit the extent to which their loans exceed the funds provided by their shareholders by the imposition of minimum "reserve ratios" and have placed various other restrictions upon their activities. In the 1980s, however, it was widely considered that those regulations were imposing excessive economic penalties, and there was a general move toward "deregulation" . Restrictions that had prevented investment banks from broadening their activities to include branch banking, insurance or mortgage lending were dropped, and reserve requirements were relaxed.

The Glass-Steagall Act -- which was repealed by the Gramm-Leach-Bliley Act in 1999 -- was designed as a method by which to protect depositors from risks associated with securities transactions. It did this by prohibiting commercial banks from participating in investment banking activities and from collaborating with full-service brokerage firms

International recommendations

In 1974 the governors of the central banks of the Group of Ten leading industrial countries had set up The Basel Committee for Banking Supervision to coordinate precautionary banking regulations , and in 1988, concern about the increased danger of systemic failure led that committee to publish a set of regulatory recommendations that related a bank's required reserve ratio to the riskiness of its loans . In 1999 further concern about the danger of instability led to the creation of the Financial Stability Forum to promote information exchange and international co-operation in financial supervision and surveillance. In 2004, the Basel Committee published revised recommendations known as Basel II intended to require banks to take more detailed account of the riskiness of their loans. Responsibility for assessing risk was placed upon the banks and the credit agencies.

During the eighteen-month period between the middle of 2007 and the end of 2008 the "crash of 2008" resulted in the failure or enforced rescue of fifteen major banks, three of the world's largest mortgage-lenders and one of the world's largest insurance companies , a disaster that has been attributed to risk-management errors on the part of the banks and the principal credit-rating agencies and to inaction on the part of the regulatory authorities. The investments whose riskiness had been wrongly assessed were derivatives based upon mortgages in the United States housing market . In 2007, an international banking panic was triggered by the revelation of serious problems at a major United States bank stemming from its holdings of such derivatives, and in 2008 an international "credit crunch" was generally attributed to a loss of mutual confidence among banks that was prompted by the unexpected failure of the United States authorities to save the Lehman Brothers bank from bankruptcy. According to the Bank of England "The global banking system experienced its most severe instability since the outbreak of World War I" .

(The article on bank failures and rescues lists the major bank failures and banking crises from the end of the first world war and the crash of 2008)

Post-crash proposals

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The authorities' reactions

; and in a 2005 lecture, Jean-Claude Trichet, the President of the European Central Bank, argued that not all bubbles threaten financial stability, and that if policy-makers attempted to eliminate all risk from the financial system, they either fail or they would "hamper the appropriate functioning of a market economy". , and by Federal Reserve Board Governor Frederic Mishkin