Abstract
This paper argues that regulatory responses to the sub-prime crisis ought to be guided by the fundamental principle that bank regulation is justified by the adverse consequences of banks taking excessive risks. It therefore proposes three reforms: requiring banks to retain a proportion of any loan that they originate, so as to reduce the risks of moral hazard; insisting that the risks involved in the financial products in which banks trade are transparent; and reforming Basel II so that the amounts of regulatory capital that banks are required to hold are less pro-cyclical than is currently the case.
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References and Notes
Smithers, A. (2008) ‘Why banks’ regulatory capital requirements need to be raised’, Butterworth's Journal of International Banking and Financial Law, Vol. 23, p. 83.
A point Joseph Stiglitz makes powerfully in his critique of the IMF's one-size-fits-all approach: (2002), Globalization and its Discontents, Penguin, London.
CDOs can be made up of a number of different asset-backed securities, so mortgage-backed securities could be mixed with investment-grade bonds and leveraged loans, which are then divided into different tranches of varying seniority, each having its own repayment and interest-earning terms, and each being given its own credit rating to represent the degree of risk thought by a credit rating agency to be involved in the particular CDO. A more detailed explanation of tranching can be found at paragraphs 58 to 63 of the House of Commons Treasury Committee's Financial Stability and Transparency 6th report (March 2008).
House of Commons Treasury Committee, Financial Stability and Transparency, 6th report (March 2008), para 66.
House of Commons Treasury Committee, Financial Stability and Transparency, 6th report (February 2008), para 46, p. 19.
Genesis 3:13.
Joint report by the Treasury, the Bank of England and the FSA, Financial stability and depositor protection: Strengthening the framework (January 2008), Cm 7308 para 2.53.
See paragraphs 169 to 178 of the House of Commons Treasury Committee, Financial stability and transparency, 6th report (March 2008).
Something recognised by both the Governor of the Bank of England and the Chairman of the Federal Reserve Board, see paragraphs 79–82 of the House of Commons Treasury Committee, Financial stability and transparency, 6th report (March 2008).
A reform recommended by Professor Buiter in his evidence to the House of Commons Treasury Committee, Financial stability and transparency, 6th report (March 2008), para 177, p. 62.
Daily Telegraph, 27th February, 2003, p. B3.
House of Commons Treasury Committee, Financial stability and transparency, 6th report (March 2008), para 39, p. 17.
House of Commons Treasury Committee, Financial stability and transparency, 6th report (March 2008), para 157, p. 55. A similar view was expressed by the Governor of the Bank of England in a speech to the Northern Ireland Chamber of Commerce in Belfast on 9th October, 2007.
House of Commons Treasury Committee. ref. 12 above, para 159, p. 56.
Hertz, P., Hamilton, N., and Ruiz, G. (2008) ‘SIVs: Is the party over?’, Butterworth's Journal of International Banking and Financial Law, Vol. 23, p. 3.
Lamfalussy, A., Looking Beyond the Current Credit Crisis, speech at the meeting of the Economic and Monetary Affairs Committee of the European Parliament with national parliaments, Brussels, 23rd January, 2008.
As explained to the House of Commons Treasury Committee, ‘a CDO-squared is a derivative structure designed to give investors exposure to a CDO’, para 38, p. 16 of its 6th report on Financial stability and transparency.
The Bank of England Act 1694 did this, restricting the Bank of England's activities to trading in gold and silver: see sections 26 and 27 of the Act.
Stiglitz, J. (2002) ‘Globalization and its Discontents’, Penguin, London, p. 101.
House of Commons Treasury Committee. Green Paper, The Run on the rock (January 2008), para 43, p. 25.
House of Commons Treasury Committee. Green Paper, ref. 20 above, para 44, p. 25.
Joint report by the Treasury, the Bank of England and the FSA Financial stability and depositor protection: Strengthening the framework (January 2008), Cm 7308 box 2.2.
City AM, 20th February, 2008, p. 4.
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2 Dr David H. McIlroy is a barrister, practicing in employment law, insolvency law and banking law at 3 Paper Buildings. He is also Visiting Lecturer in Banking Law at SOAS, University of London. He is a member of the Financial Services Lawyers Association. He has written previously on banking law in Butterworth's Journal of International Banking and Financial Law and in Nottingham Law Journal and on other topics in a variety of publications. A version of this paper was presented at the conference on ‘The Role of Law and Ethics in the Globalized Economy’, Bavarian Academy of Sciences, Munich, 22nd–23rd May, 2008.
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McIlroy, D. Regulating risk: A measured response to the banking crisis. J Bank Regul 9, 284–292 (2008). https://doi.org/10.1057/jbr.2008.15
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DOI: https://doi.org/10.1057/jbr.2008.15