Question

The collapse of the mortgage market in 2008/09-- that followed the bursting of the housing bubble in 2007/08 – is ascribed to many, many structural and functional problems rampant in the financial markets of that day. How do micro- and macro-prudential regulations propose to solve the most egregious of these problems?

Answer 1

Introduction

The debate about the global financial crisis of 2008–09 has identified a variety of causes, including large global imbalances, low world interest rates, and loose monetary policy in advanced countries. In truth, there is little consensus on the relative roles of each of these factors in triggering the crisis. In contrast, there is broad agreement that inadequate prudential regulation of the financial system was one of the main forces.

one of the key policy lessons from the crisis is the need for a radical reconsideration of prudential regulation that puts at centre stage systemic risk. However, regulatory reform alone is unlikely to make boom-bust financial cycles a thing of the past. other policy tools— monetary, fiscal, and financial—may have to play a major role to contain the buildup of systemic risk but since the question here only demand micro and macro prudential solutions we will discuss them in detail.

Meaning of Micro Prudential Regulation: Micro prudential regulation or micro prudential supervision is firm-level oversight or financial regulation by regulators of financial institutions, ensuring the balance sheets of individual institutions are robust to shocks.

                The motivation for micro-prudential regulation is rooted in consumer protection: ensuring solvency of financial institutions strengthens consumer confidence in the individual firms and the financial system as a whole. In addition, if a large number of financial firms fail at the same time, this can disrupt the overall financial system. Therefore, micro-prudential regulation also reduces systemic risk.

Meaning of Macro Prudential Regulation: Macro prudential regulation is the approach to financial regulation that aims to mitigate risk to the financial system as a whole. The main goal of macro prudential regulation is to reduce the risk and the macroeconomic costs of financial instability. It is recognized as a necessary ingredient to fill the gap between macroeconomic policy and the traditional micro prudential regulation of financial institutions

In the aftermath of the late-2000s financial crisis, there is a growing consensus among policymakers and economic researchers about the need to re-orient the regulatory framework towards a macro prudential perspective.

How can micro- and macro-prudential regulations help

In the wake of the financial crisis, the public interest in regulation of banks and other financial firms is, both self-evident and substantial.

                The global financial crisis revealed a number of shortcomings in policies and practices at financial institutions and at regulatory and supervisory agencies, These shortcomings included insufficient financial institution holdings of high quality capital and inadequate management of liquidity risk; inadequacies in basic micro prudential supervision, corporate governance and risk management practices; an under-appreciation of the scale and complexity of operations at large trading banks and other financial institutions – particularly those with activities in multiple jurisdictions – and the difficulty in resolving them when they failed; inadequate oversight of over-the-counter (OTC) derivatives markets; and insufficient visibility of the extent of interconnectedness among financial institutions, including between the regulated and shadow banking sectors, and across borders.

                The objective of the reform agenda should always be to keep balance between addressing imprudent risk allocation, and facilitating the types of productive risk-taking that are essential to economic growth.

What Regulator Suggests

The Regulators response to the crisis included four key areas for regulatory reform, that sought to harmonise some existing standards and create new ones where gaps were identified. The first area for reform addresses the riskiness of financial institutions by strengthening prudential regulatory standards, led by banking reforms known as Basel III. The second addresses the problem of an institution being ‘too big to fail’, where the threatened failure of a systemically important financial institution (SIFI) would leave authorities with no option but to bail it out using public funds. The third limits the scope for contagion arising from interconnections between counterparties in OTC derivatives markets. The fourth addresses risks arising from shadow banking, which encompasses entities and activities outside the regular banking system that are associated with credit intermediation and maturity/liquidity transformation.

• Strengthening prudential regulatory standards: The financial crisis revealed that banks in some countries were not holding enough loss absorbing capital for the risks they were taking. This was despite these institutions meeting minimum capital requirements in the periods immediately prior to, and even during, the crisis. Additionally, in the lead up to the crisis, North Atlantic banks' exposures to maturity mismatch increased markedly due to an increased reliance on short-term financing.
• Addressing the ‘too big to fail’ problem: Following the financial crisis, there has been a push in international forums to address the potential for taxpayers to be exposed to losses from government solvency support for systemically important financial institutions (SIFIs). This emphasis on ‘too big to fail’ institutions is understandable given the experiences of both the financial crisis and more recent tension in the euro area, particularly in the light of the large injections of government capital that were needed to stabilise systemically important banks, and the ‘sovereign-bank nexus’ in which undercapitalised banks degraded the solvency of their sovereigns, and vice versa
• Crisis management and resolution: further key focus of the ‘too big to fail’ work agenda is addressing cross-border contagion risks. Cross-border crisis management groups have been established for the SIFIs, and one of their key tasks is to improve recovery and resolution plans for these firms.
• Bail-in: The main argument for bail-in is that it transfers the risk of loss from taxpayers to unsecured creditors. Some argue that increasing the responsibility of unsecured creditors – which should encourage more appropriate pricing of default risk – may also strengthen the market discipline of financial institutions that might not otherwise fully internalise the social costs associated with their operations.
• Reforms to OTC derivatives markets: Since the global financial crisis, international policymakers have also sought to strengthen practices in OTC derivatives markets. The focus on this market reflects the rapid growth in the value of outstanding contracts over the decade preceding the crisis, and risk management vulnerabilities in some products, such as credit derivatives, revealed during the crisis.
• Macro prudential supervision and policy : While one contributing factor to the financial crisis was microprudential shortcomings on the part of regulators, another was an under-appreciation of the importance of certain determinants of systemic risk – in particular the ways in which interconnectedness in the financial system, and a lack of diversity in financial institutions' business models, could engender financial instability.[9] Consequently, much attention has since been directed at developing a ‘macroprudential policy framework’ to limit systemic risk.

Despite all the fuss, it looks like everybody is concerned only with creating new rules, which is just the first part of the regulation process. Few people seem to be worried about how these rules will be enforced and what the consequences will be if they are not observed or even fail, again, to meet their ends. In fact, enforcement seems to be a hidden side of financial regulation nowadays.