There are numerous aspects concerning financial regulation which the current financial turmoil has high-lighted. These include: (1) the form of deposit insurance; (2) bank solvency regimes, ‘prompt corrective action’; (3) Central Banks’ money market operations; (4) commercial bank liquidity risk management; (5) procyclicality of CARs (and mark-to-market); lack of counter-cyclical instruments; (5) boundaries of regulation, conduits, SIVs and reputational risk; (6) crisis management: (a) within countries, e.g. UK Tripartite Committee; or (b) cross-border, how to allocate the burden of cross-border defaults? This paper describes how the crisis exposed regulatory failings, drawing largely on UK experience, and suggests remedies.

In this paper, we examine the links among banking supervision, the volatility of financial flows, and economic growth. In particular, we explore whether banking regulation mitigates the adverse effects of capital flows volatility on economic growth. Using cross-country data over four decades, we find that banking supervision promotes economic growth by dampening the negative impact of volatile capital flows. The findings hold for both aggregate capital flows and its various components, and for both its net and gross counterparts, while they are also robust for various indicators of regulatory policies. The results support the argument that bank regulatory policy rules designed to ensure financial stability are beneficial to long-run economic growth.

The article contributes to the literature on financial fragility, studying how macroeconomic shocks affect supply and demand in the corporate debt market. We take into account the effect of the competitive environment, as well as the risk level, measured by companies’ default rate. The model is estimated using data from the Harmonised BACH database of corporate accounts for large euro area countries on the 1993–2005 period, in order to carry out an illustrative stress testing exercise. We measure the impact of large macroeconomic shocks (a severe recession and a sharp increase in oil prices) on the equilibrium in the debt market.

Until the 1970s, both banks and nonfinancial corporations relied on performance targets linked to their earnings per share (EPS). Over the next few decades, banks rapidly changed to emphasize return on equity (ROE) as a performance target. Investors seem aware of this change because ROE growth (EPS growth) better explains banks’ (nonfinancials’) stock market values. Also, manager compensation linked to ROE is more common for banks than for nonfinancials. This paper presents a model of a bank subject to fixed-rate deposit insurance and facing increasing competition that erodes its charter value. When the bank chooses its capital to maximize its shareholder value, its performance based on ROE appears better than its performance based on EPS. Thus, the increase in competition that started in the 1970s, along with fixed-rate deposit insurance, may explain banks’ growing preference for ROE over EPS as a performance target.

Extensive regulatory changes and technological advances have transformed banking systems to a great extent. Banks have reacted to the challenges posed by the new operating environment by creating new products and expanding their activities to some uncharted business areas. In this paper, we study how modern banking which gave birth to the off-balance-sheet leverage activities affected the risk profile of U.S. banks as well as the level of systemic risk before and after the onset of the late 2000s financial crisis. Towards this, we separate on- from off-balance-sheet leverage and capture the latter with different, yet complementary, measures which do not exist in the current literature. Special attention is paid on the deleveraging process that occurred in the banking market after the crisis erupted, which is an additional innovative feature of this study. Our findings reveal that leverage, both explicit and hidden off-the-balance-sheet, increases the individual risk of banking firms making them vulnerable to financial shocks. Reverse leverage, on the other hand, is beneficial for individual banks’ health, but is found to be harmful for financial stability. We also demonstrate that the banks which concentrate on traditional lines of business typically carry less risk compared to those involved with modern financial instruments.

Economic policy uncertainty (EPU) increases the cost of raising equity capital, especially when the economy is weak. A one standard deviation increase in the EPU index developed by Baker, Bloom, and Davis (2016) is associated with a 43 basis point increase in the price discount of seasoned equity offerings (SEOs) during the 2000−2014 period. The cross-sectional analysis shows that the EPU effect on SEO discounts is stronger for firms with greater dependence on government spending, less informative stock price, or a smaller EPU beta. Moreover, there are fewer SEO activities in periods when there is a high degree of policy uncertainty.

We study whether floods can affect financial stability through a credit risk channel. Our focus is onthe Netherlands, a country situated partly below sea level, where insurance policies exclude property damages caused by some types of floods. Using geocoded data for close to EUR 650 billion in real estate exposures, we consider possible implications of such floods for bank capital. For a set of 38 adverse scenarios, we estimate that flood-related property damages lead to capital declines that mostly range between 30 and 50 basis points. We highlight how starting-point loan-to-value ratios are one important driver of capital impacts. Our estimates focus on property damages as the main transmission channel and are also subject to a number of assumptions. If climate change continues, more frequent floods or flood-related macrofinancial disruptions may have stronger implications for financial stability than our estimates so far indicate.

We investigate a simple dynamical model for the systemic risk caused by the use of Value-at-Risk, as mandated by Basel II. The model consists of a bank with a leverage target and an unleveraged fundamentalist investor subject to exogenous noise with clustered volatility. The parameter space has three regions: (i) a stable region, where the system has a fixed point equilibrium; (ii) a locally unstable region, characterized by cycles with chaotic behavior; and (iii) a globally unstable region. A calibration of parameters to data puts the model in region (ii). In this region there is a slowly building price bubble, resembling the period prior to the Global Financial Crisis, followed by a crash resembling the crisis, with a period of approximately 10–15 years. We dub this the Basel leverage cycle. To search for an optimal leverage control policy we propose a criterion based on the ability to minimize risk for a given average leverage. Our model allows us to vary from the procyclical policies of Basel II or III, in which leverage decreases when volatility increases, to countercyclical policies in which leverage increases when volatility increases. We find the best policy depends on the market impact of the bank. Basel II is optimal when the exogenous noise is high, the bank is small and leverage is low; in the opposite limit where the bank is large and leverage is high the optimal policy is closer to constant leverage. In the latter regime systemic risk can be dramatically decreased by lowering the leverage target adjustment speed of the banks. While our model does not show that the financial crisis and the period leading up to it were due to VaR risk management policies, it does suggest that it could have been caused by VaR risk management, and that the housing bubble may have just been the spark that triggered the crisis.