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BPEA Article

Financial Regulation in a System Context

Hyun Song Shin and Stephen Morris

Abstract

The global financial crisis raises questions about the proper
objectives of financial regulation and how best to meet them. Traditionally,
capital requirements have been the cornerstone of bank regulation. However,
the run on the investment bank Bear Stearns in March 2008 led to its demise
even though Bear Stearns met the letter of its regulatory capital requirements.
The risk-based capital requirements that underpin the Basel approach to bank
regulation fail to distinguish between the inherent riskiness of an asset and its
systemic importance. Liquidity requirements that constrain the composition of
assets may be a necessary complement. A maximum leverage ratio—an idea
that has gained favor in the United States and more recently in Switzerland—
may also prove beneficial, deriving its rationale not from the traditional view
that capital is a buffer against losses on assets, but rather from the importance
of stabilizing liabilities in an interrelated financial system.

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