Rethinking Financial Regulation: How Confusions Have Prevented Progress

Abstract

The extreme fragility of the financial system that gives rise to systemic risk and crises is rooted in the incentives of people within this system and the failure of regulation to counter these incentives. The same forces that increase systemic risk also distort credit markets, exacerbate governance and control problems, and create opacity and inefficiencies. I discuss the flaws in existing capital regulations, including measurement issues, low equity levels, the risk-weighting system, and the use of debt-like hybrids such as Total Loss Absorbing Capacity (TLACs) as substitutes for equity. Regulatory reform efforts do not reflect lessons from the failure of past regulation. I also discuss briefly shadow banking and the politics of financial regulation. Confusions and flawed narratives have muddled the policy debate and, together with political forces, helped derail progress towards a safer and healthier financial system. . .