Financial Innovation and Prudential Regulation – The New Basel III Rules

Abstract

With the benefit of hindsight, financial markets and institutions proved to be much more fragile to shocks than regulators and supervisors expected. Financial innovation was accused of having played a decisive role in the recent financial turmoil. In the wake of the crisis and after the adoption of generous rescue packages and liquidity facilities by several governments, a co-ordinated effort is being made to revise prudential standards, both at the micro- and the macroprudential level. In these efforts, governments appear to follow the rules promulgated within the Basel Committee on Banking Supervision (BCBS). After an examination of the interaction between prudential regulation and financial innovation, the paper critically reviews the new prudential standards adopted within the BCBS known as ‘Basel III’, in particular those relating to regulatory capital and liquidity. One of the essential lessons of the crisis is that such requirements can no longer be limited to banks, in view of the contribution of the shadow banking system to the crisis. Furthermore, relevant national initiatives in the EU and the US are discussed and potential conflicts with the Basel III framework are pinpointed. In addition, the relevance of the prudential carve-out within the General Agreement on Trade in Services (GATS) is examined. As rule creation outside the GATS grows, rule outsourcing in the area of financial services becomes well-established, thereby increasingly pointing to the limited role of the GATS in this area.