The paper discusses why the financial system is not as resilient as policymakers currently claim – despite extensive regulatory reforms from a very weak starting point.
The paper discusses different policy strategies for making some of the debt of some banks “information-insensitive”, so that they it would be treated as safe in all but the most stressed circumstances. For the current prudential strategy, which is centred on minimum equity requirements, the paper argues that central banks and other agencies should start publishing annual staff reports on where regulatory and supervisory policy has been surreptitiously tightened or loosened.
The paper aims to spark and contribute to the debate on the second phase of stability reforms that will be needed. It sets out an alternative policy strategy based on 100% liquidity cover for the short-term debt of banks (and shadow banks), and for the creditor hierarchy of operating banks and holding companies. In this proposal, the haircut policy of central banks would become the key instrument in determining bank equity requirements and the terms on which they could borrow in secured money markets. As such, this strategy would operationalise the theoretical and empirical work of Bengt Holmström and Gary Gorton.