Regulating Risk: A Measured Response to the Banking Crisis

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 which 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 which banks are required to hold are less pro-cylical than is currently the case.