Lax financial regulation and supervision took the major blame for the global financial crisis (GFC). This initiated the most far-reaching reform in advanced economies since the Great Depression under the watchful eyes of the G20, supplemented by national initiatives in major jurisdictions.
The G20 approach was comprehensive, logical and progressive, based on four pillars: agreeing new regulations, supervising their implementation across major jurisdictions to avoid regulatory arbitrage, formulating resolution mechanisms to avoid taxpayer bailouts in case systemically important financial institutions (SIFIs) failed, and periodically stress testing the new structure for robustness.
There is notable progress on the first pillar through the Basel III capital and liquidity standards for commercial banks focused on strengthening both the quantity and quality of capital, introducing new leverage and liquidity ratios, and improving risk management, governance, transparency and disclosure norms to insulate them from the activities of shadow banking that triggered the GFC.
To address the third pillar, the Financial Stability Board (FSB) released guidelines and a list of global SIFIs whom national regulators could subject to greater regulatory oversight. The Dodd-Frank Act (DFA) in the US put in place a framework to regulate any financial institution (FI) determined to be a SIFI and also for their orderly resolution, as required. On the fourth pillar, the FSB has moved to strengthen the Financial System Assessment Programme of the IMF and stress tests are now routinely used by national regulators. The progress on the second pillar is, however, patchy.
The quick international consensus on the new Basel III norms is remarkable, notwithstanding criticism from both sides of the ideological spectrum. Intense lobbying to dilute Basel III stringency is backed by the argument that since the economy is struggling to get back to its feet, the aggressive regulatory push would only damage the recovery through accelerated deleveraging. The quick rebound of shadow banking to pre-crisis levels is also linked to the stringency of Basel III.
Critics of Basel III have emphasised on some additional concerns. First, it is ironic that although the source of the GFC lay in shadow banking, it is commercial banking that has been fixed while regulation of shadow banking remains work in progress.
Second, Basel III continues to aid pro-cyclicality through the principle of mark-to-market (MTM), notwithstanding an element of counter-cyclicality introduced through revised ratios.
Third, although financial risk, asset inflation, bubbles and leverage are all correlated, Basel III does little to prevent build-up of leverage in the financial