Risk Oversight: Regulators' Challenges

The risk environment drastically changed. Banking failures recessed in most countries since the 1980s and re-emerged abruptly with the financial crisis, shaking up the foundations of the financial system. Banking failures make risks real and convey the impression that the banking industry is always close to disaster. Mutual lending and borrowing, and trading between "highly interconnected[1] " banks, create strong interdependencies between them. An individual failure of a large bank might trigger the "contagion" effect, through which other banks suffer unsustainable losses and eventually fail. This is the foundation of the "too big to fail" principle, which became a rule in the crisis[2], and is a major challenge for the future. From an industry prospective, "systemic risk," the risk of a collapse of the entire industry because of intertwined fates of individual financial firms, is always in the background, and became the foreground in the current context. Regulations focused on systemic risk, but failed to address it efficiently.

The financial crisis changed the financial landscape entirely in a matter of weeks, with major financial firms failing, being bailed out or merging with others. Investments banks disappeared. The financial crisis triggered an economic crisis of which magnitude was compared to the 1929 crisis. Today, corrective financial and economic actions were prompt and massive, raising other issues with respect to the next regulation phase.

Regulators and standard setters face considerable challenges. Not only do they have to correct deficiencies of current regulations, and filling up the holes remaining today, but they also have to address industry-wide risk better instead of focusing only on firm-specific risk. They also need to reinforce market discipline and governance for avoiding maintaining direct support to financial firms that would encourage irresponsible risk behavior, a direct effect of implicit risk insurance by the financial authorities.

  • [1] The term is used in the White Paper of the White House (2009) [78].
  • [2] With the notable exception of Lehman Brothers' failure.
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