With the most dangerous phase of the financial crisis that began in 2007 seemingly past, attention is turning to strengthening the financial system. Policymakers are focusing on how to correct the shortcomings in the financial architecture that contributed to the outbreak of the crisis.
The crisis itself was caused by many factors, the relative importance of which will be debated for years. But whatever the underlying causes, public opinion rightly expects the regulatory environment to be reformed to prevent a repetition of the economic and human costs of the crisis.
There is a natural desire in such circumstances for “more regulation.” What is needed, however, is “better regulation,” a regime that can more readily identify emerging vulnerabilities, that can properly price risks, and that strengthens incentives for prudent behavior. In some cases, this will require additional regulation; in others, a better-targeted use of powers that regulators already have. When implementing reforms, it will be important to pursue the objective of a financial system that is not only stable, but also efficient and innovative.
It is convenient to divide the reforms into those that affect the institutional coverage of regulation, those that change the substantive content of supervisory rules, and those that modify the structure of regulatory oversight bodies.