Working Paper: CEPR ID: DP12861
Authors: Franklin Allen; Itay Goldstein; Julapa Jagtiani
Abstract: Interconnectedness has been an important source of market failures, leading to the recent financial crisis. Large financial institutions tend to have similar exposures and thus exert externalities on each other through various mechanisms. Regulators have responded by putting more regulations in place with many layers of regulatory complexity, leading to ambiguity and market manipulation.Mispricing risk in complex models and arbitrage opportunities through regulatory loopholes have provided incentives for certain activities to become more concentrated in regulated entities and for other activities to move into new areas in the shadow banking system. How can we design an effective regulatory framework that would perfectly rule out bank runs and TBTF (too big to fail) and to do so without introducing incentives for financial firms to take excessive risk? It is important for financial regulations to be coordinated across regulatory entities and jurisdictions and for financial regulations to be forward looking, rather than aiming to address problems of the past.
Keywords: bank capital regulations; bank liquidity; CET1; high-quality liquid assets; HQLAs; Basel III; Dodd-Frank Act; financial stability
JEL Codes: G12; G21; G28; G18
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| interconnectedness of large financial institutions (F65) | systemic failures (P11) |
| increased regulatory complexity (G38) | financial instability (F65) |
| Dodd-Frank Act (G28) | enhanced financial resiliency (G59) |
| enhanced financial resiliency (G59) | reduced likelihood of bank runs (E44) |
| Dodd-Frank Act (G28) | excessive risk-taking (G41) |
| regulatory coordination (L98) | effective implementation of regulations (G18) |