Under the 'Volcker Rule' in the United States, it is Proposed that Banks Will No Longer Be Allowed to Own, Invest in, or Sponsor Hedge Funds, Private Equity Funds, or Proprietary Trading Operations for Their Own Profit, Unrelated to Serving Their Customers: Can this Be an Effective Regulatory Response to Risk Issues Exposed During the Financial Crisis that Commenced in

Abstract

The financial crisis revealed the extent of the global financial system’s interconnectedness. Regulators are challenged to find new means of identifying and tackling sources of risk. A regulatory focus on micro, rather than macro prudential (i.e. network-based), models may explain recent failures. Some authors (Krahnen and Wilde), analysing risk management, conclude that it is governments’ duty to provide insurance against a system-wide crash. In contrast, Battiston and others focus on increasing connectivity and risk. Representative agent models are applied to the financial system. But Colander and Haldane have suggested that regulation must be extended from individual institutions to a systemic perspective. Network analysis theorists, such as Barabasi, contend that the implications of interactions between economic agents must be probed. They argue that a sufficiently developed appreciation of connections between firms, households and a dispersed banking sector is needed to understand risk. This will be contrasted with the response of traditional regulatory theorists (including Goodhart), calling for greater capital requirements and more stringent regulation. Regulators must devise effective means of tracking systemic linkages. Network analysis theories, focusing on interconnections between financial institutions, can provide valuable tools to assess risk in the modern financial system. The challenges posed by interconnectedness are most likely to endure. Hence the need to assess whether a proposal, such as that contained in the “Volcker Rule”, is an adequate response.