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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 chapter examines the extent to which different settlement systems affect the nature of systemic risks and the potential vulnerability of the financial system to such problems. It considers whether externalities can be reduced if individual institutions fully internalize the costs of their actions specifically by creating private submanagement systems as low-cost alternatives. The proposed standards for payments and risk control features, including the length of time during which participants are exposed to credit and liquidity risks, are addressed. The role of public intervention through prudent regulation in the payments system is discussed. The chapter concludes by discussing the establishment of minimum regulatory standards — whether in terms of interest charges, collateralization requirements, or loss-sharing agreements — and the associated tradeoffs between their costs and their ability to reduce risk.

This chapter discusses essential regulatory principles for controlling systemic risk: Systemic financial intermediaries like large and complex financial institutions (LCFIs), which are thought to be too big to fail, must be charged insurance premiums commensurate with the explicit or implicit government insurance they enjoy on a continuous basis. There should be an additional risk premium tied specifically to the systemic risk of the institutions, for example, if it exceeds a normative level, the institution pays for the additional risk taken on. Some sort of after-the-fact discipline such as “contingent capital” may be necessary; for example, debt that automatically converts into equity when losses seriously deplete equity capital. A form of functional separation or carve-outs needs to be enforced, whether by regulatory fiat or through appropriate capital charges.

This chapter explores what regulatory intervention in the governance of market infrastructure institutions is optimal. Attention is focused on how such intervention can enhance the realization of the three core objectives of securities markets regulation identified by International Organization of Securities Commissions (IOSCO), namely the protection of investors, ensuring that markets are fair, efficient, and transparent, and the reduction of systemic risk. The chapter is divided into five sections. In the first, some preliminary comments are presented. In the next three sections, the manner in which regulatory intervention in the governance of market infrastructure institutions may promote each of the IOSCO core objectives in turn is examined. The last section encapsulates these discussions and presents key lessons about how best to regulate the governance of market infrastructure institutions. In order to do so, 16 general propositions are articulated.

This chapter gives an overview of existing methods to measure systemic risk. The objective of this chapter is to provide guidance on how one should measure systemic risk in practice, including in environments with data limitations such as emerging markets and the non-regulated financial system. The chapter discusses methods to develop real time early warning signals to measure excessive credit and other aggregate financial imbalances. It also provides measures based on balance sheet data and on market data, both to analyze contagion risks and macro imbalances, including network analysis. Finally, the chapter summarizes how different measures of financial imbalances that are commonly used in policy and academic circles have performed in many financial crises over the twentieth century.

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.

The purpose of this chapter is to analyse whether a European banking system, which consists of smaller and more specialised banking firms and is regulated with a larger set of prudential rules than present, is likely to better withstand systemic shocks. The chapter adopts a novel empirical approach that relates the changes in the risk that a bank fails to changes in the degree of systemic stability. Also, the role of liquidity is examined in protecting banks against these shocks only when the banking system is under stress. While the results show that restrictions on a bank’s leverage ratio and the imposition of liquidity requirements, as in the Basel III Accord, may improve the resilience of a bank to systemic events, they also demonstrate that bank size, the share of non-interest income and asset growth (none of which are at the centre of the new regulatory landscape) are key determinants of a bank’s risk exposure. In particular, the introduction of a cap on bank absolute size appears the most effective tool, ceteris paribus, to reduce the default risk of a bank given systemic events.

Persaud provides in his chapter complementary analysis on the design of banking regulation and supervision in the light of the credit crisis. In the author's view, two fundamental flaws in financial regulation led to the biggest crisis of modern times. The first was to put market evaluations of risk at the heart of financial regulation, through external ratings and risk measures derived from market prices. The essential problem is that market prices may improperly evaluate risk in the presence of market failures. The second flaw was to assume that common standards, such as value‐accounting and risk measures are good and that diversity is bad, thus underestimating the advantages different players have to assume different risks.

This chapter analyzes a scheme to charge financial firms for their systemic risk contributions, based on the price of their contingent capital insurance. It provides an explicit calculation formula for contingent capital insurance and illustrates how the systemic risk surcharge varies with institution size, its leverage, risk (equity volatility), and, importantly, its correlation with rest of the economy or with the systemically important part of the financial sector. Calculations of both the tax and the insurance premium for major financial firms prior to the 2007 financial crisis show that the measure accurately chose the systemic firms, consistent with recent statistical-based measures of systemic risk. A commentary is also included at the end of the chapter.

This chapter presents the “new” financial regulatory framework that relies on both microprudential and macroprudential policies to manage systemic risk. It gives an overview of macroprudential tools and then discusses the tradeoffs involved in choosing an optimal policy mix and the practical considerations when implementing these tools. It also analyses whether macroprudential policy setting should be within the same organization or a different organization than microprudential policy. The chapter also presents a critical review of the Basel III regulatory framework and the EU and US regulations. The analysis of the effectiveness of macroprudential tools is illustrated with case studies. The chapter emphasizes the preventive role of macroprudential policy in limiting the possibility and impact of financial crises, and concludes that the macroprudential policy mix needs to be chosen such that it deals both with the time and cross-sectional dimensions of systemic risk. This requires a multitude of measures and there is a risk that they will conflict with each other even though they share the same objective. Also, macroprudential policy should be combined with strong supervision, with an increased focus on the buildup of systemic risk through correlated risk exposures and risk taking by systemically important financial intermediaries.

This chapter gives a definition of systemic risk, describes the real consequences of systemic risk, and presents a taxonomy and illustration of systemic financial crises throughout history. It explains that systemic risk is not limited to financial stability but also implies real effects for the economy at large, arising from an impairment of the financial system that causes substantial negative aggregate output and employment effects.