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The paper discusses the reform of capital regulation of banks in the wake of the financial crisis of 2007/2009. Whereas the Basel Committee on Banking Supervision seems to go for marginal changes here and there, the paper calls for a thorough overhaul, moving away from risk calibration and raising capital requirements very substantially. The argument is based on the observation that the current system of risk-calibrated capital requirements, in particular under the model-based approach, played a key role in allowing banks to be undercapitalized prior to the crisis, with strong systemic effects for deleveraging multipliers and for the functioning of interbank markets. The argument is also based on the observation that the current system has no theoretical foundation, its objectives are ill-specified, and its effects have not been thought through, either for the individual bank or for the system as a whole. Objections to substantial increases in capital requirements rest on arguments that run counter to economic logic or are themselves evidence of moral hazard and a need for regulation.

The failure to spot emerging systemic risk and prevent the current global financial crisis warrants a reexamination of the approach taken so far to crisis prevention. The paper argues that financial crises can be prevented, as they build up over time due to policy mistakes and eventually erupt in slow motion. While one cannot predict the precise timing of crises, one can avert them by identifying and dealing with sources of instability. For this purpose, policymakers need to strengthen top-down macroprudential supervision, complemented by bottom-up microprudential supervision. The paper explores such a strategy and the institutional setting required to implement it at the national level. Given that the recent regulatory reforms that have been undertaken to address systemic risks are inadequate to prevent and combat future crises, the paper argues that national measures to promote financial stability are crucial and that the Westphalian principles governing international financial oversight should be rejected. The paper proposes that while an effective national systemic regulator should be established, strong international cooperation is indispensable for financial stability.

The present analysis sheds light on the setting up a regional rating agency in Asia in the wake of recent financial crisis. We investigate the policy facing a financial regulator while evaluating whether or not to admit new entrants into the credit rating market. In an incomplete contracting framework, we show that an impartial financial regulatory body (represented by a benevolent supranational organization) can facilitate credit ratings of high quality by allowing for the entry of new rating agencies on a non-single basis than it does for a mere single entry. This finding is caused by increased competition among the rating agencies, which induces higher quality of rating services even should rating agencies still exert below their maximum level of efforts.

This paper investigates the spread of what started as a crisis at the core of the global financial system to emerging economies. While emerging economies had exhibited some resilience through the early stages of the financial turmoil that began in the summer of 2007, they have been hit hard since mid-2008. Their deteriorating fortunes are only partly attributable to the collapse in world trade and sharp drop in commodity prices. Things were made worse by emerging markets' exposure to the turmoil in global finance itself. As 'innocent bystanders,' even countries that had taken out 'self-insurance' proved vulnerable to the global 'sudden stop' in capital flows. We critique loanable funds theoretical interpretations of global imbalances and offer an alternative explanation that emphasizes the special status of the U.S. dollar. Instead of taking out even more self-insurance, developing countries should pursue capital account management to enlarge their policy space and reduce external vulnerabilities.

The recent crisis was characterized by massive illiquidity. This paper reviews what we know and don't know about illiquidity and all its friends: market freezes, fire sales, contagion, and ultimately insolvencies and bailouts. It first explains why liquidity cannot easily be apprehended through a single statistics, and asks whether liquidity should be regulated given that a capital adequacy requirement is already in place. The paper then analyzes market breakdowns due to either adverse selection or shortages of financial muscle, and explains why such breakdowns are endogenous to balance sheet choices and to information acquisition. It then looks at what economics can contribute to the debate on systemic risk and its containment. Finally, the paper takes a macroeconomic perspective, discusses shortages of aggregate liquidity and analyses how market value accounting and capital adequacy should react to asset prices. It concludes with a topical form of liquidity provision, monetary bailouts and recapitalizations, and analyses optimal combinations thereof; it stresses the need for macro-prudential policies.

After analyzing the different reasons why the financial system and also the regulatory framework induced procyclicality, this paper reviews the experiences of three countries which have introduced dynamic provisioning as a regulatory tool to limit procyclicality. The case of Spain - the country with the longest experience - is reviewed, as well as those of Colombia and Peru - countries that have recently adopted dynamic provisioning. A number of policy lessons are drawn from that comparison.

The recent financial crisis has shown that financial innovation can have devastating systemic impacts. International standard setters' and national regulators' response has been a global concerted effort to overhaul and tighten financial regulations. However, at a time of designing stricter regulations, it is crucial to avoid a backlash against financial inclusion. In this chapter, we argue that greater financial inclusion presents opportunities to enhance financial stability. Our arguments are based on the following insights: Financial inclusion poses risks at the institutional level, but these are hardly systemic in nature. Evidence suggests that low-income savers and borrowers tend to maintain solid financial behavior throughout financial crises, keeping deposits in a safe place and paying back their loans. Institutional risk profiles at the bottom end of the financial market are characterized by large numbers of vulnerable clients who own limited balances and transact small volumes. Although this profile may raise some concerns regarding reputational risks for the central bank and consumer protection, in terms of financial instability, the risk posed by inclusive policies is negligible. In addition, risks prevalent at the institutional level are manageable with known prudential tools and more effective customer protection. The potential costs of financial inclusion are compensated for by important dynamic benefits that enhance financial stability over time through a deeper and more diversified financial system. In the following pages, we present the current state of financial inclusion globally. We also explore some trends in financial inclusion and what the most effective policies are to favor it. In doing so, we suggest that innovations aimed at countering financial exclusion may help strengthen financial systems rather than weakening them.

This paper investigates the prevailing financial regulatory structures and impact of the current financial turmoil on banking performance in four Asian economies: the People's Republic of China (PRC); Hong Kong, China; Singapore; and Taipei,China. Both the PRC and Hong Kong, China operate under a fragmented financial regulatory structure, while Singapore and Taipei,China have integrated structures. We examine the role of an integrated financial regulatory structure in helping financial institutions mitigate the impact of the financial crisis, using financial indicators of banks' capital structure and operating performance in these four economies between 2003 and 2008. Our analysis of the indicators reveals that banking performance under a fragmented financial regulatory structure is not worse than under integrated regulation. This implies that financial regulatory structure is not the main reason why Asian financial institutions suffered only limited losses from the current global financial crisis. However, given the growing complexity of the global financial system, and the relative weakness of current financial regulatory structures in Asia, this paper suggests that East Asian governments should refer to the Lamfalussy Process in the European Union and set up an Asia Financial Stability Dialogue to facilitate policy coordination for regional financial sector stability and development.

The ongoing global economic crisis has punished Asian economies severely, despite the fact that its origins derive from outside the region. The global economic crisis was transmitted through real and financial channels, underscoring how vulnerable the region is to external shocks. This paper explores the microeconomic origins of the financial crisis and endeavors to ascertain how crises might be mitigated in the future through better regulation, supervision, and institution-building. Moreover, it makes the case for closer economic cooperation in order to internalize key externalities associated with modern global finance. This cooperation, in turn, should take place at the appropriate level, with incentives for cooperation at the global, regional, and subregional levels. It explores the potential for the creation of an Asian Financial Stability Board and deepening other initiatives in Association of Southeast Asian Nations (ASEAN)+3 and ASEAN forums. However, it stresses that the most important financial reforms in Asia will need to take place at the national level.

This paper discusses the role of state intervention for prevention, containment, and resolution of financial crises based mainly on the Korean experience during the 1997 Asian financial crisis. Crises in emerging market and developing economies tend to be more complicated than those faced by advanced economies because they are twin crises: financial and currency crises. Such crises require the development of a comprehensive strategy covering the stabilization of the domestic financial market and the foreign exchange market, closely coordinated responses by different government bodies, an extraordinary effort for financial restructuring, and the introduction of a new regulatory framework. This effort should be based on an effective crisis management team of experts given a clear mandate with well defined power; strong political support; effective communication with the market players, both domestic and foreign; and sufficient mobilization of public funds. In this regard, this paper emphasizes the importance of building a reliable information base, prompt actions, orchestrating political consensus, and a balanced approach to restructuring and regulation among different types of financial institutions. The paper also highlights the need for a new international financial architecture matching the rapid integration into the global market of the financial markets of emerging and developing economies while their currency remains non-convertible.

The paper discusses the reform of capital regulation of banks in the wake of the financial crisis of 2007/2009. Whereas the Basel Committee on Banking Supervision seems to go for marginal changes here and there, the paper calls for a thorough overhaul, moving away from risk calibration and raising capital requirements very substantially. The argument is based on the observation that the current system of risk-calibrated capital requirements, in particular under the model-based approach, played a key role in allowing banks to be undercapitalized prior to the crisis, with strong systemic effects for deleveraging multipliers and for the functioning of interbank markets. The argument is also based on the observation that the current system has no theoretical foundation, its objectives are ill-specified, and its effects have not been thought through, either for the individual bank or for the system as a whole. Objections to substantial increases in capital requirements rest on arguments that run counter to economic logic or are themselves evidence of moral hazard and a need for regulation.

It is widely believed that the practice of securitization is one of the causes that led to the 2007-08 financial crisis. In this paper, I show that securitized products such as collateralized debt obligations (CDO) are particularly vulnerable to systematic risk and tend to show higher tail risk. These characteristics, in turn, are closely associated with joint failures and systemic risk. In order to achieve greater stability of the financial system, it is important to prevent the recurrence of the collapse of specific markets as this may lead to the collapse of other components of the financial system. From this perspective, the financial regulations that should be applied to these problematic financial products and their relation to possible systemic risks are discussed.

Reichen die auf dem G-20-Gipfel beschlossenen Maßnahmen aus, die Finanzmärkte zu regulieren und die Wahrscheinlichkeit zukünftiger Krisen zu senken? Für Rolf J. Langhammer, Institut für Weltwirtschaft, Kiel, dienten die Beschlüsse des G-20-Gipfels der Krisenüberwindung und dem Versuch, ein abgestimmtes Verhalten von nationalen Regulierungsbehörden herbeizuführen. Jenseits beider Ziele blieben aber viele Probleme ungelöst Doris Neuberger, Universität Rostock, sieht in den auf dem G-20-Gipfel beschlossenen Maßnahmen einen Durchbruch zur Stärkung der Überwachung und Regulierung der Finanzmärkte. Allerdings reichten sie nicht aus, um einen systemstabilisierenden funktionsfähigen Wettbewerb sicherzustellen. Nach Ansicht von Hermann A. Wagner, Frankfurt School of Finance & Management, brachten die G-20-Beschlüsse keinen wirklichen Durchbruch bei der Regulierung der Finanzmärkte. Man könne allenfalls von einem Durchbruch für die Erkenntnis, dass es eigentlich nur gemeinsam geht, sprechen. Für Thorsten Polleit, Frankfurt School of Finance & Management, bleibt die Krisenursache, nämlich »das staatliche System, indem Geld per Kredit geschaffen wird«, durch die Politikmaßnahmen unangetastet. Einen Ausweg aus dem Krisenzyklus sieht er in einem Reformkonzept für „gutes Geld in Form des »Free Banking«, dem »Privatisieren des Geldes«. Und Irwin Collier, Freie Universität Berlin, befasst sich mit der Regulierung auf den US-Finanzmärkten.

The paper analyses the causes of the current crisis of the global financial system, with particular emphasis on the systemic elements that turned the crisis of subprime mortgage-backed securities in the United States, a small part of the overall system, into a worldwide crisis. The first half of the paper explains the role of mortgage securitization as a mechanism for allocating risks from real estate investments and discusses what has gone wrong and why in the implementation of this mechanism in the United States. The second half of the paper discusses the incidence of systemic risk in the crisis. Two elements of systemic risk are identified. First, there was excessive maturity transformation through conduits and structured-investment vehicles (SIVs); when this broke down in August 2007, the overhang of asset-backed securities that had been held by these vehicles put significant additional downward pressure on securities prices. Second, as the financial system adjusted to the recognition of delinquencies and defaults in US mortgages and to the breakdown of maturity transformation of conduits and SIVs, the interplay of market malfunctioning or even breakdown, fair value accounting and the insufficiency of equity capital at financial institutions, and, finally, systemic effects of prudential regulation created a detrimental downward spiral in the overall financial system. The paper argues that these developments have not only been caused by identifiably faulty decisions, but also by flaws in financial system architecture. In thinking about regulatory reform, one must therefore go beyond considerations of individual incentives and supervision and pay attention to issues of systemic interdependence and transparency.