The Prudential Regulation of Financial Institutions

Abstract

It is now six years since a devastating financial and economic crisis rocked the global economy. Supported strongly by the G20 process, international regulators led by the Financial Stability Board have been working hard ever since to develop new regulatory standards designed to prevent a recurrence of these events. These international standards are intended to provide guidance for the drawing up of national legislation and regulation, and have already had a pervasive influence around the world. This paper surveys recent international developments concerning the prudential regulation of financial institutions: banks, the shadow banking system and insurance companies. It concludes that, while substantial progress has been made, the global economy nevertheless remains vulnerable to possible future financial instability. This possibility reflects three sets of concerns. First, measures taken to manage the crisis to date have actually made the prevention of future crises more difficult. Second, the continuing active debate over virtually every aspect of the new regulatory guidelines indicates that the analytical foundations of what is being proposed remain highly contestable. Third, implementation of the new proposals could suffer from different practices across regions. Looking forward, the financial sector will undoubtedly continue to innovate in response to competitive pressures and in an attempt to circumvent whatever regulations do come into effect. If we view the financial sector as a complex adaptive system, continuous innovation would only be expected. This perspective also provides a number of insights as to how regulators should respond in turn. Not least, it suggests that attempts to reduce complexity would not be misguided and that complex behavior need not necessarily be accompanied by still more complex regulation. Removing impediments to more effective self-discipline and market discipline in the financial sector would also seem recommended.