How should the banking system be regulated?
• The post Bretton woods era was marked with political disputes by developed countries and new policy regimes in response to the failures of previous crises. During the Bretton Woods system, capital controls were an instrument to prevent the instability but with the rise of the Euromarkets in the 1960’s capital controls had been reduced and became difficult to enforce effectively. Towards the end of the 1970’s both the UK and US had adopted financial deregulation which encouraged competition between banks and this led to developing countries adopting similar methods.
• Since the Bretton Woods era, there has been more integration between economies and this has led to a more globalised world. Global capital mobility along with global lending has increased, and advances in technology have allowed financial innovation that tested state boundaries encouraged more globalization, not less. Trade continued to expand as it had during the Bretton Woods era, but after Bretton Woods there was a shift towards more neoliberal policies which favoured liberalisation and the openness of markets.
• Many of the debates that took place after the financial crisis were concerned with an increasing role of regulation around the world with the help of governments. Firstly, after the financial crisis it was clear to see that the goal of financial stability had to be included in monetary policy but what tool could be used to do this effectively? Interest rate setting by central banks was not seen as being sufficient as it would be difficult to achieve two different objectives using the same tool. The response by the FSB has been to implement a new tool known as the Basel III which is said to have a countercyclical effect to credit raises and inflation. Secondly, those institutions that posed a systemic risk had to be identified and looked at to see what improvements could have been made. There have been debates about crisis management mechanisms and banking methods which are both aimed at preventing the triggering of a financial crisis.
• In the past, regulation has been undertaken to improve the risk management practices in individual banks whereas the focus should be on the systemic externalities and consumer protection. There has been a call for a ‘level playing field’ as financial cycles differ from country to country therefore regulation will be different for all countries. This is why it would be harder to regulate finance at international level. Furthermore, as long as financial institutions believe that they state will bail them out, we will continue to have problems no matter how much regulation is put into place. International regulation differs from domestic regulation due to the fact that at international level, the geographic scale of systemic risk is bigger. As financial markets become more integrated, network interdependency increases and therefore the failure of a foreign institution will have a big impact at domestic level.
• The turmoil witnessed in the financial crisis poses a challenge to traditional views of financial regulation. I believe that the purpose is to create a more stable base for the financial system as a whole and to prevent a reoccurrence of a financial crisis. Financial regulation can also promote competition between countries and increase efficiency among institutions. On the other hand, governments use regulation to balance private and public interests.