Making Banking Safe
30 Pages Posted: 25 Jul 2023
Date Written: July 18, 2023
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, Regulation, Supervision, Resolution, Federal Reserve, Federal Deposit Insurance Corporation, Stagflation, Stress Test, Federal Home Loan Banks, Capital requirements, Liquidity requirements, Liquidity risk, Systemically important markets
JEL Classification: G21, G28
Suggested Citation: Suggested Citation