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Over the past few years, financial regulators have devoted considerable attention to the development of consolidated capital rules for financial conglomerates. This chapter explores the theoretical justifications for these new requirements and explains that the case for consolidated capital oversight consists of four separate lines of argument: technical weaknesses inherent in traditional entity-level capital requirements; unique risks associated with financial conglomerates; additional diversification benefits that financial conglomerates enjoy; and recognition that financial firms increasingly employ modern risk management techniques that work on a group-wide basis. The specific rules for consolidated capital requirements that the Basel Committee proposed in April 2003 are reviewed, and it is argued that the Basel proposals constitute a relatively rudimentary system of consolidated capital requirements, dealing primarily with the technical weaknesses of entity level capital and making little effort to deal with more subtle issues such as unique risks of financial conglomerates, diversification benefits, and modern risk-management techniques. A number of significant practical considerations contribute to the relatively limited scope of the Basel Committee's proposal, which will likely prevent the development of a more comprehensive system of consolidated capital oversight for financial conglomerates in the foreseeable future.

Currently, banks, securities firms, and insurance companies conduct trading businesses that involve many of the same financial instruments and several of the same counterparties but that are subject to very different capital regulations. This chapter examines why these regulatory differences exist and what they imply for differences in minimum capital requirements for position risk. It considers differences in the definition and measurement of regulatory capital, and quantifies differences in the capital charges for position risk by reference to a model portfolio that contains a variety of financial instruments, including equity, fixed income instruments, swaps, foreign exchange positions, and options — instruments that may appear in the portfolios of securities firms, banks, or insurance companies. For most leading firms in the financial services industry, however, market forces, not minimum regulatory capital requirements, appear to play the dominant role in firms' capital decisions. The chapter concludes by considering measures to enhance market discipline.

This chapter considers capital adequacy and capital regulation of insurers and reinsurers. A basic theme is that capital standards should be less stringent for financial sectors characterized by greater market discipline and less systemic risk. Because market discipline is greater and systemic risk is lower for insurance than in banking, capital requirements should be less stringent for insurers than for banks. Similarly, because market discipline is generally greater in reinsurance (wholesale) markets than in direct insurance (retail) markets, capital requirements and related regulation plausibly need not be as stringent for reinsurers as for direct insurers. Current capital requirements and related solvency regulation for US and EU insurers and reinsurers are largely consistent with significant market discipline in the insurance and reinsurance sectors. Any federal regulation of US insurers/reinsurers, harmonized regulation of EU reinsurers, consolidated oversight of financial conglomerates, and increased centralization of regulatory authority to supervise insurance and other financial activities should be designed with full recognition of the limited systemic risk and strong market discipline in insurance/reinsurance and avoid undermining that discipline.

This introductory chapter begins with a discussion of the proposed revision of the rules for the regulation of capital adequacy developed by the Basel Committee on Banking Supervision. It then describes the differences among financial institutions and the three ways to ensure adequate capital: market discipline, supervisory review of firm economic models used to determine capital, and command and control regulation. An overview of the chapters included in this volume is presented.

This chapter identifies two alternative forms of prudential regulation. The first set is formed by regulations that directly control financial aggregates, such as liquidity expansion and credit growth. The second set, which can be identified as the ‘pricing-risk-right’ approach, works by providing incentives to financial institutions thereby avoiding excessive risk-taking activities. Regulations in this category include ex-ante risk-based provisioning rules and capital requirements that take into account the risk features particular to developing countries. The main finding of the chapter is that contrary to policy intentions, the first set of regulations — the most commonly used in developing economies — can exacerbate rather than decrease financial sector fragility, especially in episodes of sudden reversal of capital flows. In contrast, the second set of prudential regulation can go a long way in helping developing countries achieving their goals. The chapter advances suggestions for the sequencing of implementation of these regulations for different groups of countries.

Chapter 7 looks at organization and management of financial supervisors. The Gramm-Leach-Bliley Act of 1999 reflected deregulatory sentiment and left serious gaps in the regulatory system. The apparently benevolent period of the early 2000s, when it did not seem easily possible for financial institutions to make serious mistakes, lulled not only financial firms and rating agencies, but also policy makers and supervisors into complacency. Supervisors were reluctant to bring enforcement actions against firms that appeared to be so profitable. Supervisors often were unable or unwilling to set limits when firms engaged in regulatory arbitrage, especially to avoid capital requirements. Informal prodding was the approach of choice for supervisors who feared that a supervised firm might move to another supervisor that seemed more congenial. If a supervised firm left to another regulator, the agency losing jurisdiction over the firm would lose budget resources. Interagency cooperation to set limits on risky practices was difficult and meant that interagency guidance often was weak and late.

This chapter analyses the consequences of growth and development of derivatives markets in developing countries in the context of deregulated financial markets. It discusses both the economic usefulness of derivatives, and the potential misuses and abuses that are facilitated by these financial instruments. The chapter also discusses certain public interest concerns with derivatives markets such as trading practices and the use of collateral (also known as margin). One of the most important concerns is the growth in risk taking in proportion to the amount of capital underlying such investments, and in turn this leads to large public concerns about the impact on financial sector and overall economic stability. The chapter concludes with a policy proposal that is designed to curtail if not eliminate these problems while encouraging the use of derivatives for productive purposes.

Offers an in-depth discussion of regulatory and competitive issues in German banking. Emphasising that regulation, market structure, and competitive conduct are deeply interrelated the authors look at bank regulation from an Industrial Organisation perspective. Special consideration is given to the three-pillar structure of German banking comprising private, public, and co-operative banking institutions as well as to the driving forces that shaped bank regulation and supervision from its beginning in 1931. To assess market structure and competition in Germany’s banking market, the available empirical evidence is carefully discussed. A concluding section points to the challenges stemming from the decision to phase out state-guarantees for public banks.

This introductory chapter begins by briefly setting out the book's purpose, which is to offer a perspective on what happened during the recent financial crisis and especially on the lessons to be learned in order to avoid a repetition of this large-scale meltdown of financial markets, industrial recession, and public deficits. It then provides a historical perspective on the regulation of the banking sector, followed by discussions of the challenges facing prudential regulation and the development of an adaptive regulatory system in a global world. It argues that the previous trend toward decreasing capital requirements and increasing delegation of oversight to banks and credit-rating agencies clearly requires a correction, namely a strengthening of regulation. In the recent crisis, the pendulum can be expected to swing in this direction.

Alfred Chandler wrote a great deal on finance capital in the development of big business. In making bold and provocative statements, he provided scholars with a variety of stimulating ideas. To a large extent, however, we still do not know whether Chandler’s assertions were correct. Ultimately, the value of revisiting Chandler’s research on finance capital in the rise of US big business is to understand how much research needs to be done and the questions it needs to address.

This chapter explores the consequences of adding Pillar 2 alongside Pillar 1 in terms of bank risk taking and the scale of bank lending. It also concentrates on the interaction between Pillar 1 and Pillar 2 when banks are able to use risk management to cheat in relation to capital requirements. The disciplinary effect of the franchise value vanishes when closure rules allow costless recapitalization. The presence of costs of recapitalization decreases the cost of deposit insurance but increases the probability of default. Without Pillar 2/Prompt Corrective Action (PCA), even when banks' compliance is relatively good (limited cheating), risk-based capital regulation (RBCR) may be effective in the sense that, for higher levels of RBCR, banks do indeed hold higher amounts of capital. Pillar 2/PCA is most effective in decreasing the cost of deposit insurance when compliance is relatively poor.

This chapter discusses the Basel III capital requirements. Following the 2008 financial crisis, the Basel Committee on Banking Supervision issued reform proposals for capital regulation, entitled “Basel III,” as part of a series of initiatives sponsored by the Group of 20 (G20) nations. The centerpiece of Basel III is a series of amendments to the capital adequacy standards embodied in the worldwide framework for capital regulation created by Basel I and extensively revised and expanded under Basel II. These amendments specify three broad revisions to the Basel I and II architecture: (1) increases in minimum mandatory bank capital requirements; (2) new measures to control countercyclicality in capital regulation; and (3) new restrictions on what instruments qualify as capital and adjustments to risk-weightings.

Banking was the first financial service to be subject to regulatory harmonization. However, banking regulation has mainly been designed to foster integration in the EU, rather than setting prudential rules (e.g. capital requirements). Over time, the EU has downloaded international capital requirements (the so-called Basel accords), albeit taking into account European ‘specificities’. In the negotiations of the Basel accords, the EU did not present a united front because its member states had different priorities, rooted in their domestic political economies. Banking regulation is a dual (i.e. a state and federal) competence in the US. The US, together with the UK, was able to upload its domestic capital requirements internationally in the late 1980s. The Basel I accord set in place a process of path-dependence and subsequently the US agreed to download Basel II and III.

In this chapter, panellists discuss the messy legislative process that produced Dodd-Frank (James Overdahl compares it to a barroom brawl) and how it, along with Basel III and reinvigorated enforcement of existing laws, has affected banks. Professor Anil Kashyap characterizes the financial crisis as a series of runs on institutions involved in maturity transformation. He believes that Dodd-Frank does little to address this problem. Professor Anjan Thakor suggests that Special Capital Accounts could be used to insure that banks have sufficient capital without diminishing incentives for creditors to monitor them. John Walsh, former acting Comptroller of the Currency, argues that while parts of Dodd-Frank strengthen the banking sector, others make it difficult for banks to earn a suitable return on their capital.

This chapter evaluates the usage of regulatory risk constraints as an antidote to banking panics. In particular, it considers two forms of substantive risk constraint that are widely used in financial regulation: portfolio constraints and capital requirements. It finds that these techniques, standing alone, do not provide a satisfactory answer to the panic problem. The chapter demonstrates that, at some level of stringency, such risk constraints will compromise the banking system’s ability to assist the state in achieving its monetary objectives. Furthermore, there can be no assurance that any set of risk constraints that is compatible with the state’s monetary objectives will succeed in stabilizing banking. This analysis forms the basis for a critique of various “narrow banking” proposals, which continue to claim very prominent adherents in the economics profession. The chapter also finds problems with recent proposals to impose extremely high capital requirements on banking firms. Finally, the chapter identifies serious shortcomings in laissez-faire approaches to banking, including so-called “mutual fund banking” proposals.

This chapter evaluates the usage of regulatory risk constraints as an antidote to banking panics. In particular, it considers two forms of substantive risk constraint that are widely used in financial regulation: portfolio constraints and capital requirements. It finds that these techniques, standing alone, do not provide a satisfactory answer to the panic problem. The chapter demonstrates that, at some level of stringency, such risk constraints will compromise the banking system’s ability to assist the state in achieving its monetary objectives. Furthermore, there can be no assurance that any set of risk constraints that is compatible with the state’s monetary objectives will succeed in stabilizing banking. This analysis forms the basis for a critique of various “narrow banking” proposals, which continue to claim very prominent adherents in the economics profession. The chapter also finds problems with recent proposals to impose extremely high capital requirements on banking firms. Finally, the chapter identifies serious shortcomings in laissez-faire approaches to banking, including so-called “mutual fund banking” proposals.

A natural economic response to systemic risk, as a form of negative externality, is to look attaxation to correct it. However, this chapter argues that systemic risk is not a standard externality. First, a ‘polluter pays’ approach is inapplicable because the polluter is insolvent in a systemic crisis and cannot pay. Second, the equivalence between taxation and regulation holds only under a set of very strict assumptions The imposition of a levy increases banks per-loan funding requirements and potentially total amount of debt in the system. The levy may thereby perversely exacerbate potential systemic crises unless paid in capital, in which case it returns full circle to capital regulation.

Following the financial crisis, UK preferences shifted decisively in favour of trading up bank capital and liquidity requirements. To reassure voters, elected officials intervened in the regulatory process by strengthening the domestic institutional architecture for banking regulation. Financial regulators leveraged this political support to overcome resistance from the financial industry, but also pushed for international/EU harmonization of capital requirements to avoid damaging the UK’s competitiveness. Internationally, UK regulators therefore acted as pace-setters and exerted significant influence over the design of the Basel III Accord. However, at the EU level, the UK was forced to act as a foot-dragger by prolonging negotiations over the Capital Requirements Directive IV (CRD IV) in an attempt to resist Franco-German efforts to water down the rules. But UK negotiators were more successful in leveraging domestic constraints to oppose the Commission’s attempt to impose the ‘maximum’ harmonization of bank capital.

This chapter analyses the policy-making process for bank capital adequacy standards, focusing on the interaction between the European and global levels. It traces the emergence of supranational standards from the European Community’s First Banking Coordination Directive in 1977 through the Basel Capital Accords to the current EU’s Capital Requirements Directive IV. This chapter demonstrates how the EU functions as an intermediating variable influencing preferences of private and especially public actors. And it explains how and why public policy-makers are not always prey to regulatory capture. The negotiations on bank capital adequacy standards take place in exclusionary policy-making forums, leading to skewed argument pools. As a result, policy-makers have developed shared assumptions including the superiority of market mechanisms and the desirability of levelling the playing field.