Regulating Finance: The Political Economy of Unfinished Reform

Regulating Finance: The Political Economy of Unfinished Reform

Observers looking for evidence of the importance of a sound international financial regulatory architecture in an age of financial globalization should look no further than the recent global financial crisis. The crisis laid bare the limitations of the global financial architecture that had emerged in a piecemeal fashion since the collapse of the Bretton Woods system in the early 1970s.

To begin with, the crisis demonstrated the inadequacy of the Basel Accords, which for three decades formed the core of the international banking regulatory regime. The Basel Committee of central bankers had spent the better part of the late 1990s and early 2000s renegotiating the original Basel I agreement, which set minimum capital requirements for international banks. The crisis has revealed the limitations of this agreement, and in particular of shifting part of the task of calculating capital charges on the banks’ own internal models and data, as the major international banks entered the crisis with only limited capital and excessive leverage.

Most importantly, though, the crisis revealed the failure of international financial regulation to keep up with developments in financial markets. While international regulatory cooperation in finance had developed along sectoral lines, financial innovation had over the same period shifted a greater amount of credit and risk intermediation to entities—such as the so-called shadow banking system, over-the-counter (OTC) derivatives markets, hedge funds and other private pools of capital—that were not subject to the oversight of any single regulator. After the onset of the crisis, the decision by the U.S. government to bail out some of the major players in the OTC derivatives market, such as Bear Stearns and American International Group (AIG), to prevent a systemic crisis, and the market panic triggered by the lack of information regarding who was holding these products and the associated risk, have made clear the case for regulating these markets.

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