Debt, Deregulation and Financial Crises
Chapter 23: The inability of capital requirements to prevent or moderate financial crises
The adoption of capital requirements led regulators to focus on the individual institution in isolation, ignoring the ever tighter linkages between institutions and sectors and the systemic interactions they created. Moreover, they failed to see that capital requirements pushed institutions and the financial system as a whole in a pro-cyclical direction. In the aftermath of the crisis, it became clear that capital requirements are a tool that failed. Capital evaporated and governments, not markets, were required to provide the capital cushion needed to prevent total collapse. The downward spiral set in motion by falling prices and charges against capital in the fall of 2008 argues for a view of capital as a threat to solvency, not a cushion. The Fed’s struggle to provide liquidity systemically suggests that central banks must build a source of systemic funding that, like reserves, is renewable and immediately available to all financial sectors in a downturn.
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