Working Paper: CEPR ID: DP18302
Authors: Stephen Cecchetti; Kermit L. Schoenholtz
Abstract: Following the bank failures of 2023, what should be done to make the financial system safe? We draw two key lessons from the recent episode: first, a banking system that relies heavily on supervisory discretion is unlikely to be resilient; second, authorities with emergency powers to bail out banks during a panic cannot credibly commit to refrain from doing so. The only way to address these challenges is to have a rigorous framework focused on crisis prevention.To meet this goal, we argue that regulation should be more rule-based (less reliant on supervisory discretion); simpler and more transparent; stricter and more rigorous; and more efficient in its use of resources. Applying these principles to a range of proposals, we identify reforms that best address the glaring deficiencies made so clear by recent events: namely, increase capital and liquidity requirements; shift to mark-to-market accounting; and improve the transparency, flexibility and severity of capital and liquidity stress tests.
Keywords: Financial Stability; Financial Regulation; Federal Reserve; Capital Requirements; Liquidity Requirements
JEL Codes: G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| reliance on supervisory discretion (G28) | resilience of banking system (F65) |
| existence of emergency powers (H12) | credibility of commitments (D70) |
| absence of rigorous framework (C62) | vulnerability to crises (H12) |
| reforms (increasing capital and liquidity requirements, shifting to mark-to-market accounting, improving stress tests) (G28) | resilience of banking system (F65) |