The financial crisis and regulation reform

Abstract

The financial crisis has been the result of the interaction of economic factors and financial innovation. Wide global imbalances characterized the years before the crisis. In many industrialized countries, especially the United States, disequilibria developed in some sectors of the economy: the result was the real estate bubble and the sharp increase in household sector debt. The financial sector went through a period of profound changes caused by innovation and the development of credit risk transfer mechanisms and of the so-called ‘shadow banking system’. The growth of financial activity was not followed by an equal strengthening of market infrastructures. Low interest rates and misaligned incentives for bank managers and rating agencies induced the search for yield, excessive risk taking and an increase in on- and off-balance sheet leverage. In this article, we describe the causes of the crisis and focus on the measures that have been proposed. The Financial Stability Board set out a roadmap; the Basel Committee, endorsed by G20 leaders, elaborated a comprehensive plan to strengthen banking regulation. The Basel Committee aims at promoting a more resilient banking system and improving its ability to absorb financial and economic shocks. In summary, the regulation gaps need a global response in three key areas: regulatory capital, interconnectivity among intermediates, incentives and transparency.