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.

A fair level of provisions on bad and doubtful loans is an essential input in mark-to-market accounting, and in the calculation of bank profitability, capital and solvency. Loan-loss provisioning is directly related to estimates of loan-loss given default (LGD). A literature on LGD on bank loans is developing but, surprisingly, it has not been exploited to address, at the micro level, the issue of provisioning at the time of default, and after the default date. For example, in Portugal, the central bank imposes a mandatory provisioning schedule based on the time period since a loan is declared ‘non-performing’. The dynamic schedule is ‘ad hoc’, not based on empirical studies. The purpose of the paper is to present an empirical methodology to calculate a fair level of loan-loss provisions, at the time of default and after the default date. To illustrate, a dynamic provisioning schedule is estimated with micro-data provided by a Portuguese bank on recoveries on non-performing loans. This schedule is then compared to the regulatory provisioning schedule imposed by the central bank.

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.