The way forward with banking regulatory reform: We do not know how effective recent banking sector regulatory reforms will be in future, economics and finance professor at IESE Business School Xavier Vives writes in CEPR’s policy portal, Vox. “Regulation became lax in the years before the subprime crisis. Capital ratios as a percentage of assets for banks declined, as well as liquidity buffers,” Vives writes, and “prudential regulation did not properly take macroprudential concerns into account. The lack of attention before the crisis to liquidity requirements led to diminishing liquid assets in bank balances. Banks had no cushion to limit asset sales when they needed cash, and hence contributed to systemic risk… Finally, there were inadequate resolution procedures and tools, which increased the cost of restructuring and liquidation.” Following the crisis, regulatory reform, according to Basel III regulations, focused on macroprudential regulations to counteract the external effects of bank behaviour that impact systemic risk, including initiatives to separate commercial and investment banking, ring-fencing retail activities in banks, and being able to “resolve failing financial firms in an orderly manner.”

That said, Vives notes that, while the reforms are heading in “the right direction,” we can still question if they go far enough. “Structural banking reform proposals to separate investment and commercial banking activities are bound to have mixed results. On one hand, they will tend to lower the complexity of banking institutions and improve the resolvability and credibility of resolution procedures, as well as reduce the likelihood of conflicts of interest and interdependencies within group and financial markets. On the other hand, they may increase the supervisory burden and the danger of misidentifying prohibited or permitted activities, and limit scope and diversification economies.” Vives believes “prudential regulation should employ an all-inclusive approach that considers interactions between conduct (capital, liquidity, disclosure requirements, macroprudential ratios) and structural (activity restrictions) instruments.”

Coordination between prudential regulation and competition policy is also required, “because of the trade-off between competition and financial stability that is inherent in regulatory imperfections.” Vives says establishing regulation and supervisory procedures “will be challenging when many of the basic theoretical and empirical foundations of regulation and supervision … are not fully developed.” There are many questions ahead of regulators right now, particularly as “regulation is typically driven by the previous crisis, not the next one.”