Financial Crises, Regulatory Responses

Financial crises of varying severity seem all too frequent, some of global dimension. Major financial disruption was averted until the crisis of 2007-09 but even after serious reforms, the financial system has been hit by periodic disruption, including the failure of major banks in the US and Switzerland in spring 2023. What are the common elements among these crises, what are the differences? In some instances, crises have brought about significant regulatory reform. Yet how is it that financial crises seem to recur with such frequency? And recur despite regulatory efforts to avoid them?

Using a mix of economics and law-related materials, we plan to address these themes:

1) Are financial crises foreseeable or unforeseeable? Do they arise from processes internal to the financial sector (such as the 'leverage cycle'?) or from external events, such as changes in the political landscape that change the terms of financial globalization?

2) Are there more or less stable structures for the financial system? The financial system aims to match suppliers of capital (savers) and users of capital (business users and consumers). From a stability point of view, is such financial intermediation better done through financial institutions or through markets?

3) Stable structures, part II: Is there an optimum firm size? Should certain financial market activities be combined (for efficiency and diversification) or separated?

4) Are we better off with rigorous schemes of crisis avoidance or efficient resolution mechanisms, especially if long periods of financial stability inevitably lead to increased leverage, asset price inflation and a resulting steeper crash? Are we better off by focusing attention on mopping up smaller, more frequent crashes?

5) Do recurrent crises flow from the political constraints on optimum regulation? There are two facets to this question: first, the desire of incumbent political leaders to promote reelection chances by producing economic growth or greater home ownership, which favors expansionary credit policies; second, the firm-level competition within the financial sector to protect and expand rents.

6) The financial environment is driven by the interplay of legislation, regulation, governance and monetary policy. To what extent can independent central bank intervention through monetary policy correct for legislative or regulatory debility?

7) Do the goals of differently tasked regulators conflict in a way that may undermine systemic stability? How does the disclosure focus of securities regulators fit with the safety and soundness goals of financial regulators?

8) International coordination and its limits: do the concessions made to obtain sufficient national buy-in to achieve a widespread international regime (necessary to avoid free-riding) undermine the effectiveness of the international regulatory architecture? One example where this issue has arisen prominently in recent years is the zero risk-weighting on all OECD sovereign debt under the Basel accords.