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Rethinking financial stability

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The paper provides an overview of the state of progress of international regulatory reforms after the global financial crisis, and assesses whether they have achieved their objectives and where gaps remain. The authors find that additional insights gained since the start of the reforms paint an ambiguous picture on whether the current level of bank capital should be higher or lower. Additionally, they present evidence that a combination of different regulatory metrics can achieve better outcomes in terms of financial stability than reliance on individual constraints in isolation.

Bank of England – Staff Working Paper No. 712
23 February 2018
Source: Bank of England

Authors:
David Aikman, Bank of England
Andrew Haldane, Bank of England
Marc Hinterschweiger, Bank of England
Sujit Kapadia, European Central Bank

>  Rethinking financial stability

Abstract:

The global financial crisis has been the prompt for a complete rethink of financial stability and policies for achieving it. Over the course of the better part of a decade, a deep and wide-ranging international regulatory reform effort has been under way, as great as any since the Great Depression. We provide an overview of the state of progress of these reforms, and assess whether they have achieved their objectives and where gaps remain. We find that additional insights gained since the start of the reforms paint an ambiguous picture on whether the current level of bank capital should be higher or lower. Additionally, we present new evidence that a combination of different regulatory metrics can achieve better outcomes in terms of financial stability than reliance on individual constraints in isolation. We discuss in depth several recurring themes of the regulatory framework, such as the appropriate degree of discretion versus rules, the setting of macroprudential objectives, and the choice of policy instruments. We conclude with suggestions for future research and policy, including on models of financial stability, market-based finance, the political economy of financial regulation, and the contribution of the financial system to the economy and to society.

Introduction

The global financial crisis has been the prompt for a complete rethink of financial stability and policies for achieving it. Over the course of the better part of a decade, a deep and wide-ranging international regulatory reform effort has been underway, as great as any since the Great Depression.

On cost grounds alone, a systematic rethink and reform of regulatory standards has been fully justified. While the costs of the global financial crisis are still being counted, it seems likely they will be the largest since at least the Great Depression. Two approaches are typically used to gauge these costs of crisis: the cumulative loss of output relative to its trend, and the cumulative fiscal costs of supporting the financial system.

Chart 1 looks at the path of output relative to a simple measure of its pre-crisis trend in the US, UK, France and Germany after the Great Depression of 1929 and the Great Recession of 2008. In either case, it is debatable whether estimated “pre-crisis trends” were sustainable, as they may have been artificially inflated by credit booms. Nonetheless, it is clear that the output losses from both crises, relative to pre-crisis trends, have been extremely large and long-lasting.

In the US, the level of output is currently around 13% below a continuation of its pre-crisis trend. Ten years into the Great Depression, output was around 28% below its pre-crisis trend. Even if not quite on the scale of the 1930s, the global financial crisis has imposed a huge opportunity cost on US citizens. In the UK, the losses since the Great Recession, currently at around 16% of pre-crisis GDP, are larger than in the US and indeed larger than those that followed the Great Depression. The crisis opportunity costs for UK and euro-area citizens have been the highest for at least a century.

Much the same picture emerges if we look at measures of the fiscal cost of crisis. Again, there are a number of methods for gauging this cost. But one simple metric is to look at the pattern of government debt-to-GDP ratios after the Great Depression and Great Recession, recognising that the larger part of the debt sustainability cost of crisis typically arises from the denominator shrinking than from the numerator rising. Chart 2 plots these debt-to-GDP ratios, again for the US, UK, France and Germany.

It suggests that, in the decade after the Great Depression, levels of government debt relative to GDP had increased by around 28 percentage points in the US, 9 percentage points in Germany, but actually declined in the UK. Since the Great Recession, levels of debt relative to GDP have increased , on average, by 28 percentage points for the same set of countries. The fiscal cost of the Great Recession, at least on this metric, is larger than during the Great Depression.

It is against this backdrop that policymakers internationally have engaged in a deep and wide rethink, rewrite and reform of the global regulatory rules of the game. Wide, reflecting the multi-faceted nature of the problems, market failures and market frictions exposed within the financial system during the crisis. Deep, reflecting the severity of the hit to balance sheets, risk appetite and economic activity that the crisis has inflicted and continues to inflict.

The next section reviews these regulatory reform efforts and their impact on bank balance sheets and market metrics of banking risk. With a number of reforms yet to be fully enacted, it is too soon to be reaching definitive conclusions. Nonetheless, some of the key questions thrown up by these regulatory reforms – conceptual, empirical and practical – are now reasonably clear. We also have almost a decade’s worth of additional evidence and research on which to draw when assessing these issues.

The following sections discuss some of those issues, drawing on new research and evidence: the calibration of regulatory standards, balancing the costs and benefits of tighter regulation; the overall system of financial regulation, balancing underlaps and overlaps, simplicity and complexity, discretion and rules; the impact of reforms on incentives in the financial system, in particular incentives to avoid regulation; and the evolving role of macroprudential regulation in safeguarding stability of the financial system.

The financial system is dynamic and adaptive. So any financial regulatory regime will itself need to be adaptive if it is to contain risk within this system. In the terms used by Greenwood et al (2017), resilience needs to be “dynamic”. As past evidence has shown, too rigid a regulatory system will soon become otiose. And there are already calls, in some quarters and in some countries, for a rethink and rewrite of regulatory rules on which the ink is barely dry. This poses both opportunities and threats.

The opportunities arise from the need to keep the regulatory framework fresh and agile. With the best will in the world, no one could say with certainty how the far-reaching and interwoven reforms to regulation over the past decade will precisely land. Judging how the financial system might adapt to future trends in financial technology is even harder to predict. As new evidence, incentives and innovation arise in the financial system, the opportunity is created for regulators to learn and adapt the regulatory framework (Carney, 2017a).

Equally, there are also threats to financial stability from any process of change. History is replete with examples of regulatory standards being diluted or dismantled in the name of enhancing the dynamism of the financial system and the economy. To follow this course unthinkingly would risk repeating regulatory mistakes from the past, recent and distant. Only ten years on from the biggest crisis in several generations, there are already some eerie echoes of those siren voices. With that in mind, we conclude with some thoughts on issues which might be fruitful for future research on regulatory policy.

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