Preemptive Tools to Mitigate Financial System Risk : Lessons from the Recent Global Financial Crisis

Deposit insurance can protect financially unsophisticated savers and prevent depositor runs, but it creates a need for regulation to control excessive risk-taking by insured banks. Several regulatory flaws were exposed by the 2008-2009 financial crisis. They include: risk-based capital standards that led banks to retain securitization risks; tax policy that dissuaded banks from issuing sufficient equity capital; and the failure of non-equity capital, such as subordinated debt, to absorb the losses of large banks. This paper discusses actual and proposed regulatory reforms in three areas: restrictions on bank assets and activities; required capital; and deposit insurance. While some reforms have been productive, others have been ineffective. Regulatory reforms often focus on large banks' accounting (book) value regulatory capital ratios whereas investor confidence is based on large banks' market value capital ratios. Financial stability would be enhanced by more simple regulation that is based on forward-looking market value measures rather than backward-looking accounting value measures