Editorial ( 429,21 KB )

 

Reforming the financial system

  The worldwide economic crisis that erupted in 2007 highlighted the excessive risk accumulated by the financial system as a whole. In previous years, economic expansion had been exceptionally strong and, moreover, took place within a context of low inflation, rock bottom interest rates and ample liquidity. This cocktail explains why the financial system's expansion was more pronounced than in a normal expansionary cycle and also why the degree of leveraging went beyond what was reasonable, without the regulatory authorities becoming aware of the excessive risk-taking.

  Can suitable regulation anticipate and prevent imbalances in the financial system? Probably not, given the difficulty of anticipating all the possible behaviours, developments and innovations. Neither would this be desirable since rigid, narrow regulations would hinder credit flows and would prevent the sector from fulfilling its role as an intermediary. But it is possible to learn from the experience of the crisis and to attempt to repair the current mechanisms with a view to detecting, early enough, excessive risk-taking in the financial system.

  In this Report we present various articles that examine some aspects of the current reforms being carried out on the financial system. Proposals are explored that aim to stop institutions that believe themselves to be «too big to fail», given that their bankruptcy would lead to great economic collapse, from taking excessive risks. For these «systemically important» financial institutions, regulatory proposals attempt to raise capital and liquidity requirements above those recently set by Basel III, to introduce taxes and duties that reflect the social cost of systemic risk, tax «excessive» income in the financial sector or establish mechanisms to intervene in institutions in order to make a potential bail-out easier.

  Another focus of interest lies in proposals aimed at offsetting or eliminating the procyclical nature of the financial system, i.e. the fact that it does not dampen economic cycles but rather accentuates them. Basel III introduces two key elements to cushion the procyclical effect: capital «buffers» and calculating credit provisions according to the losses expected. The aim is for institutions to set up reserves or provisions during the good times that can be used up during a recession.

  Deficiencies in mechanisms to supervise the financial system come to light in adverse scenarios so that, to be on the safe side, one initiative has been to subject institutions to the so-called stress tests. This exercise consists of defining highly negative scenarios and calculating their effect on banks. The United States led the way in carrying these out and the tests helped to restore investor confidence. These tests were also carried out in Europe last year but, in spite of their good effect initially, their inability to predict the collapse of the Irish banking system seriously damaged their credibility. There will be a second round of tests during the next few months, revising the methodology employed in 2010.

  Lastly, the Report also looks at derivatives, given their important role in the crisis, and in particular at credit derivatives, proposing various measures in order to avoid their destabilizing potential. However, reform does not stop here as there are many other issues under review, such as the role of rating agencies or the structure of macroprudential supervision. It is to be hoped that these reforms achieve their aims but without hindering the flow of credit, for the good of economic recovery, both in terms of its extent and sturdiness.

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