Financial Regulation and Stability
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Financial Regulation and Stability

Lessons from the Global Financial Crisis

Charles Goodhart and Dimitrios P. Tsomocos

This book addresses the interaction of monetary and regulatory policy to achieve the important goal of price and financial stability. The authors show how financial stability can be assessed and measured continuously, and discuss the interrelationships between liquidity and default. Without default there would be no concern about liquidity. But the financial crisis was not just a liquidity problem, and requires a general equilibrium model. Their general equilibrium analysis demonstrates how policy should depend on understanding all the relevant factors.
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Chapter 2: The Macroprudential Toolkit

Anil K. Kashyap, Richard Berner and Charles A.E. Goodhart

Abstract

Most treatments of financial regulation worry about threats to the banking system and the economy from defaults or credit crunches. This paper argues that the recent crisis points to fire sales through capital markets as another source of financial and economic instability. Accounting for fire sales implies several changes to the standard approach. First, if there are three channels of instability, then three regulatory tools are needed to deliver stability. Second, if only a single capital tool and a single liquidity tool are available, then there is a risk that using them pushes activity into the shadow banking system. Third, liquidity requirements on the asset side of bank balance sheets are conceptually different from liquidity requirements on the liability side. The paper starts with a review of the recent theoretical work on fire sales that form the building blocks for a next generation of models of the financial system. A summary of some evidence suggesting that fire sales were present in the crisis is offered. Next, the paper outlines a general equilibrium framework that can be used to think about a financial system in which default, credit crunches, and fire sales are all possible. The paper concludes with a discussion of the regulatory options and some speculation on how such a framework could be extended.

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