Post Crisis Challenges to Bank Regulation

The current crisis has swept aside not only the US investment banks with the best reputation but also the consensual perception of banking risks, contagion and its implication for banking regulation. As everyone agrees now, risks where mispriced, they accumulated in neuralgic points of the financial system, and where amplified by procyclical regulation and the instability and fragility of financial institutions. Stating that the current crisis is, fundamentally, a crisis of the regulatory framework may appear as a radical overstatement that makes regulatory authorities the only culprit in a complex crisis where the business cycle, monetary policy, current account imbalances, financial innovation, greed and incompetence may be seen as equally essential. Yet, in the end we have to acknowledge that the crisis is a crisis of the regulatory framework. First, by definition, regulation is in place to cope with market failures, namely with the bankruptcy of financial institutions that puts a halt to all contracts and transactions and interferes with the well functioning of the payment system. So, it is tautologically true that, because bank regulation is supposed to prevent financial crisis the current crisis is mainly a regulatory failure. Second, in the same way the incentives of the baker are to provide better bread because of the profit he will make, so we expect bank managers to produce financial innovations (in the broad Schumpeterian meaning) with profit as their objective, thus creating value to shareholders. So, if the incentives of bank managers or their way to compute future shareholders' value are biased, the ultimate responsibility lies with the regulator