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Implications for Financial Regulations Jon Danielsson London School of Economics

Implications for Financial Regulations Jon Danielsson London School of Economics. The Financial Crisis Conference FMG/LSE October 1, 2007. On the Costs of Crises. World Bank study Controlling Fiscal Costs of Banking Crises by Honohan and Klingebiel

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Implications for Financial Regulations Jon Danielsson London School of Economics

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  1. Implications for Financial RegulationsJon DanielssonLondon School of Economics The Financial Crisis Conference FMG/LSE October 1, 2007

  2. On the Costs of Crises • World Bank study Controlling Fiscal Costs of Banking Crises by Honohan and Klingebiel • 90% of the cost of banking crisis is due to inappropriate policy responses • Unlimited deposit guarantees • Open–ended liquidity support • Repeated recapitalizations • Debtor bail–outs • Regulatory forbearance

  3. Banking has ChangedRegulations have not kept up • Originate and hold model of banking no longer relevant • Focus is on prudential behavior of individual banks • But we can have a crisis even if every bank behaves prudently • Northern Rock was (apparently) prudently run according to FSA • Over–reliance on models • Tick–the–box approach to supervision • Network effects (e.g. liquidity) have had lower priority than compliance with prudential rules • Regulators assumes some responsibility for banks behavior

  4. Deposit Insurance, Moral Hazard and Lending of Last Resort • Effective deposit insurance requires extensive supervision • S&L crisis • Prompt corrective action? • Banks should not fund deposit insurance • A liquidity crisis can happen for no fault of banks • Is there moral hazard in lending to a bank that acted prudently according to the regulator?

  5. Where to Regulate • Cannot separate monetary policy from lending of last resort • Cannot separate lending of last resort from financial stability • Cannot do financial stability without knowing what banks are up to • Japanese arrangement? • Or combine BofE and FSA • Surely the treasury does not want the political risk

  6. Future Arrangements • Are rating agencies irreplaceable? • Securitization is here to stay • Is Basel II irrelevant/dangerous? • Narrow banking for regulated institutions? • Regulators need to consider systemic risk

  7. A Longer–Term Strategy for RegulationJon Danielsson and Charles Goodhart • Objectives of regulations should be clear • Regulation should be evidence based and explicit • Simplicity is a virtue — Models should be avoided • Regulations should not dictate day–to–day activities • Use incentives, but carefully

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