What the financial crisis tells us
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The financial crisis triggered by the U.S. subprime-mortgage crisis is considered to be the severest economic trauma since the Great Depression of the 1930s. It has proved that inadequate and ineffective regulation is one of the main causes for this crisis, and emphatically shown that minimum regulation simply doesn't work.
During this crisis, I've observed four measures taking root in international financial regulation.
More rigorous and broader regulation
The G20 London Summit–Joint Communiqué clearly states that all financial institutions, markets and instruments must be given proper supervision and management, which is also emphasized in the U.S. Financial Regulatory Reform Bill. The bill was proposed by the Obama administration in June 2009 and signed into law on July 21 this year. It shows that the U.S. is building a more complete and thorough regulation system, including almost all the financial activities, such as financial institutions' operation, mergers, mortgage loans, credit ratings, and derivatives markets. According to the bill, the U.S. Federal Reserve is given additional powers to supervise high-risk firms, such as hedge funds and insurance companies, and two new agencies – the Financial Stability Oversight Council and the Consumer Financial Protection Bureau – have been established.
From rules-based regulation to principles-based regulation
For a long time, Western countries have followed the rules-based regulation approach, in which lawmakers and regulators try to prescribe in great detail exactly what companies can do and cannot do. However, the financial crisis indicates that the change of market environment has been too fast for regulation institutions to adapt, and if the distance between the market and regulation is too far, a crisis will break out.
As opposed to rules-based regulation, the principles-based regulation is a principle-oriented and results-oriented regulatory approach, which helped the U.K. financial system maintain stability. Now, many countries have begun to take this kind of approach to regulation.
Greater macro-prudential regulation to reduce systemic risk
This crisis shows that the original regulations paid more attention to micro-regulation and ignored the systemic risk within the financial system. The macro-prudential regulation concerns itself with the stability of the financial system as a whole, and judges the financial risk with GDP in order to prevent the instability of the entire financial system caused by negative effects among financial institutions. To strengthen the macro-prudential regulation, the U.S. government has intensified the supervision of large financial institutions that may cause systemic risks, and the EU has established the European Systemic Risk Board to identify, monitor and warn of financial risks to the system.
Before this financial crisis, the central banks and regulatory institutions were usually separate in the West. Now the new trend is to promote the central banks' supervisory power and enhance communication and cooperation between central banks and regulatory institutions.
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