This paper discusses the problems exposed by the global financial crisis in the areas of financial regulation and supervision and possible solutions. It describes and evaluates current proposals regarding the role of the central bank as a systemic regulator, the pros and the cons of locating financial supervision in the central bank, and the conflicts and synergies that such an arrangement entails. Once a crisis erupts, central bank liquidity injections constitute a first line of defense. But in the longer term these injections create a trade-off between price and financial stability, and may compromise central bank independence. Problems exposed by the crisis include the growth of a poorly regulated shadow financial system, shortermism in executive compensation packages and consequent adverse incentive effects, the too-big-to-fail problem, procyclicality in the behavior of financial institutions, conflicts of interest in the rating agencies industry and the trade-off between the scope of intermediation through securitization and transparency in the valuation of assets. The paper also discusses international dimensions including international cooperation in regulatory reform and the scope for limiting exchange rate variability. The conclusion points out inherent difficulties in distinguishing ex ante between a fundamentals based expansion and a “bubble

We analyse the effect of failing reinsurance cover on the stability of Dutch insurers. As insurers often reinsure themselves with other (re)insurers, a firm's loss could spread contagiously through the sector. Using a unique and confidential data set on reinsurance exposures, we gain insight into the reinsurance market structure and perform a scenario analysis to measure contagion risks. Considering entities on a standalone basis, we find no evidence of systemic risk in the Netherlands, even if multiple reinsurance companies fail simultaneously. At group level our analysis points to the contagion risk of in-house reinsurance structures, given that such in-house reinsurance parties are generally not higher capitalised than other group members.

The original Taylor rule establishes a simple linear relation between the interest rate, inflation and the output gap. An important extension to this rule is the assumption of a forward-looking behaviour of central banks. Now they are assumed to target expected inflation and output gap instead of current values of these variables. Using a forward-looking monetary policy reaction function, this paper analyses whether central banks’ monetary policy can indeed be described by a linear Taylor rule or, instead, by a nonlinear rule. It also analyses whether that rule can be augmented with a financial conditions index containing information from some asset prices and financial variables. The results indicate that the monetary behaviour of the European Central Bank and Bank of England is best described by a nonlinear rule, but the behaviour of the Federal Reserve of the United States can be well described by a linear Taylor rule. Our evidence also suggests that only the European Central Bank is reacting to financial conditions

This paper examines why some financial stress episodes lead to economic downturns. The paper identifies episodes of financial turmoil in advanced economies using a financial stress index (FSI), and proposes an analytical framework to assess the impact of financial stress – in particular banking distress – on the real economy. It concludes that financial turmoil characterized by banking distress is more likely to be associated with deeper and longer downturns than stress mainly in securities or foreign exchange markets. Economies with more arm's-length financial systems seem to be more exposed to contractions in activity following financial stress, due to the greater procyclicality of leverage in their banking systems

This paper studies whether compliance with the Basel Core Principles for effective banking supervision (BCPs) is associated with bank soundness. Using data for over 3000 banks in 86 countries, we find that neither the overall index of BCP compliance nor its individual components are robustly associated with bank risk measured by individual bank Z-scores. We also fail to find a relationship between BCP compliance and systemic risk measured by a system-wide Z-score

This paper analyzes the effect of the business cycle on the regulatory capital buffers of German local banks in the period 1993–2004. The capital buffers are found to fluctuate countercyclically over the business cycle. The evidence supports that low-capitalized banks do not catch up with their well-capitalized peers over the observation period and they do not decrease risk-weighted assets during a recession. This finding suggests that their low capitalization does not force them to retreat from lending

Building an unbalanced panel of United States (US) bank holding company (BHC) and commercial bank balance-sheet data from 1986 to 2008, we examine the relationship between short-term capital buffer and portfolio risk adjustments. Our estimations indicate that the relationship over the sample period is a positive two-way relationship. Moreover, we show that the management of such adjustments is dependent on the degree of bank capitalization. Further investigation through time-varying analysis reveals a cyclical pattern in the uncovered relationship: negative after the 1991/1992 crisis, and positive before 1991 and after 1997.

While the current capital adequacy framework, Basel II, aims to make banks’ capital requirements more sensitive to the underlying risk of the assets, it may also introduce an additional source of procyclicality in the banking sector. In this paper we assess the potential cyclicality of Basel II for the entire bank portfolio. This is in contrast to previous studies which have taken into account only parts of banks’ assets, and also neglected the potential cyclicality of bank capital. We apply a detailed data set covering a relatively long period to analyse the cyclicality of both bank capital and Basel II capital requirements. Moreover, we employ a more comprehensive system of models than applied in the existing literature. Consistent with previous evidence, we find a substantial increase in the calculated Basel II capital requirements at the same time as bank capital deteriorates in a recession scenario. However, we also find that the cyclicality of Basel II capital requirements may be effectively contained if risk weightings are based on a sufficiently long observation period which includes economic downturns

We investigate whether the introduction of fixed-price U.S. federal deposit insurance in 1933 increased the risk-taking of banks over the succeeding period. We examine 60 financial institutions and find that banks and trusts in general became more risky after the introduction of deposit insurance. However, a subset of well-performing banks appears to have reduced their risk. Deposit insurance also reduced the incentives of depositors to discriminate between ex ante weaker and stronger banks thus reducing depositor discipline in return for greater banking system stability.

In Australia, the 1890s depression was associated with a banking system collapse, whereas financial problems during the 1930s depression were far less severe. While the behaviour of the financial sector was obviously pro-cyclical during the 1890s episode, there were signs of more prudent behaviour and stronger financial institutions leading up to the 1930s depression. This change was aided by a change in the competitive environment and by the experience of the preceding financial crisis. The lessons from Australia's depression experiences are of relevance to debates about the causes of the current global financial crisis and required regulatory reforms.