“Financial Risk and Crisis Management after
the Global Financial Crisis” Series No.4 (1/2016)

The US-origin Global Financial Crisis andthe Development of Financial Regulations 1

Hanazaki Masaharu i
Professor, Graduate School of Commerce and Management,
Hitotsubashi University

This document is an English translation of the original Japanese, whichappears in the Jan. 2016 edition of The Japan Economic Research InstituteMonthly Report, published by The Japan Economic Research Institute.
11

1. Introduction
The sudden outbreak of the financial crisis in the US enveloped the
major investment bank Lehman Brothers in its turmoil, triggering an
unprecedented phenomenon that led to its collapse in September 2008.
However, the Lehman collapse was not the sole result of this financial
crisis. Influential investment banks, such as Bear Stearns and Merrill
Lynch, also fell into financial distress and were acquired by majorcommercial banks. The largest insurance company in the US, AIG, wasbailed out by the US government and the Federal Reserve Board (FRB)
when it was hit by the crisis. Furthermore, as the US-origin crisis
rapidly spread to Europe, prominent EU-based financial institutions
also received public fund injections as they also fell into financial
distress; this kind of contagion effects spread across both regions. In
addition, in the fall of 2008, these phenomena that were primarily
contained within the financial sector rapidly cascaded into the real
sector, triggering an economic crisis.
Just after this outbreak of the global financial crisis, reexaminationof global financial regulations started and drastic proposals for theiralteration have manifested in the Basel Committee on Banking
Supervision; the statements issued therein are in the process of being
incorporated into financial systems. In the US as well, the generaltrend of financial deregulation that started in the 1970s is concluding
and the most significant financial regulation reform since the Banking
Act of 1933 is now emerging.
The first half of this paper clarifies the context and characteristics ofthis global financial crisis. The period of financial expansion in the
2000s that led to the financial crisis can be characterized by thefollowing points, which are significantly different from those of thepast. The first is the expansion of securitization. The US loan
originators aggressively expanded loans and incorporated these loans
into securitized products, finally sold them to institutional investors.
One type of loans used for securitization was the so-called subprime2

loan, residential mortgage for low-income persons. These securitized
products, based on underlying assets such as subprime loans, weregreatly devalued as a result of the housing bubble burst and thesubstantial rise in defaults on subprime mortgages, thereby leading to
the disarray of financial markets worldwide.
The second is the development of the shadow banking system. The
scale of the shadow banking system, which functions as a detachedorganization from banks themselves, significantly developed in the
2000s. The scale of their assets exceeded even that of the local GDPs in
the US, the UK, and the Euro zone. These shadow banks’ excessiverisk-taking behavior increased the aggregate volume of risk assets inglobal financial markets beyond the tolerable level.
The third is the expansion of credit default swaps (CDSs). A CDS is akind of the over-the-counter derivatives designed to transfer credit
risks. Although the purchasers of CDS protection receives the benefit
of being able to avoid loss associated with defaults in corporate bonds ,etc., they are obliged to expose themselves to the default risk ofprotection sellers. This type of risk is called counterparty risk.
The fourth is the medium-term trend of financial deregulations in
the US. Although the US’s traditional financial system was strictly
regulated, it shifted toward deregulation in the 1980s and beyond.
Particularly the practical abolishment of the separation between
banking businesses and security businesses can be considered to be acause of the expansion of the bubble led by the various financial
institutions.
Financial regulations after the Lehman shock can be mainly
characterized by increasingly stringent initiatives, such as toughening
capital adequacy requirements, the introduction of new liquidity
regulations, and higher capital adequacy requirements for large-scalefinancial institutions; such regulations also had an emphasis on the
new aspect of macro prudential policy.

3However,

since

the

financialsystemhas

theimportantcharacteristics of the institutional capital 2 , with its highly public
nature, we have to consider how to effectively function one. In such an
aspect, we might not conclude that the present reforms may beappropriate. The second half of this paper summarizes the contents ofthe financial regulatory reforms in recent years and clarifies the points
in dispute for these reforms.

2. Backgrounds and Characteristics of the Global Financial
CrisisThe global financial crisis, which quickly spilled over its epicenter in
the US across the rest of the world, was not an accident at all. Several
factors led to its emergence, thereby triggering the crisis. Extracting
these factors will provide a clear picture of the characteristics of thecrisis.
2.1 The Expansion of the Securities Market
The first factor is the extreme expansion of transactions in capital
markets. That movement is unrealistically isolated from the real
economy. Table 1 indicates developments of outstanding in stocks anddebt securities from 2001 to 2008, the year of occurrence of theLehman shock, based on IMF statistics.
In 2001, the global stock market capitalization was at 29 trillion
dollars, with debt securities at 42 trillion dollars, totaling 71 trillion,
or 2.3 times the size of the GDP at the time (31 trillion dollars). After
that, mainly private securities and stocks expanded substantially. As a

The institutional capital refers to one part of social common capital as
advocated by Professor Hirofumi Uzawa. The institutional capita l includes
institutions such as education, medical service, financial system, and judicature.
Horiuchi (1995) focuses on the issues of financial order, a major function of thefinancial system, clarifying the traits inherent to the institutional capital.
24result, an upward trend of total securities value was observed, peaking
at 145 trillion dollars in 2007, and also 2.7 times the 55 trillion dollar
GDP at the time. The yearly average rate of increase from 2001 to 2007
was 17.5% for private debt securities and 14.5% for stock market
capitalization.
Table 1: Development of the Size of Stock and Debt Security Markets

GlobalGDP
Stock Market Capitalization
Debt Securities
PublicPrivateSecurities Total
vs. GDP (%)

31.0
28.9
41.8
22.2
19.6
70.7
228.1

32.2
22.8
43.6
16.6
27.0
66.4
206.2

36.3
31.2
51.3
20.0
31.3
82.5
227.3

41.3
37.2
57.8
23.2
34.6
95.0
230.0

44.6
42.0
59.7
23.4
36.3
101.7
228.0

48.4
50.8
69.2
25.8
43.4
120.0
247.9

(Units: USD, trillions)2008
Avg. Growth Rate,
2001-2007 (%)
54.8
61.2
9.96
65.1
33.5
14.49
80.2
83.3
11.47
28.6
31.6
4.31
51.6
51.7
17.51
145.3
116.8
12.76
265.1
190.8

USA

GDP
Stock Market Capitalization
Debt Securities
PublicPrivateSecurities Total
vs. GDP (%)

10.1
13.8
18.5
9.7
8.8
32.3
319.8

10.5
11.1
19.0
4.5
14.5
30.1
286.7

11.0
14.3
20.7
5.0
15.7
35.0
318.2

11.7
16.3
22.3
5.5
16.8
38.6
329.9

12.5
17.0
24.1
5.9
18.2
41.1
328.8

13.2
19.6
27.0
6.2
20.8
46.6
353.0

13.8
19.9
30.3
6.6
23.7
50.2
363.8

14.4
7.3
29.1
8.8
20.3
36.4
252.8

5.34
6.29
8.57
-6.22
17.95
7.63

EU

GDP
Stock Market Capitalization
Debt Securities
PublicPrivateSecurities Total
vs. GDP (%)

7.9
6.8
11.8
4.9
6.9
18.6
235.4

8.7
5.7
12.8
4.9
7.9
18.5
212.6

10.5
7.8
16.6
6.2
10.4
24.4
232.4

12.3
9.3
19.3
7.3
12.0
28.6
232.5

12.9
9.6
18.7
6.7
12.0
28.3
219.4

13.7
13.1
23.2
7.7
15.5
36.3
265.0

15.7
14.7
28.2
8.8
19.4
42.9
273.2

14.4
11.7
30.6
7.9
22.7
42.3
293.8

12.13
13.71
15.63
10.25
18.80
14.95

Japan

GDP
Stock Market Capitalization
Debt Securities
PublicPrivateSecurities Total
vs. GDP (%)

4.2
2.3
6.9
5.3
1.6
9.2
219.0

4.0
2.1
6.9
4.8
2.1
9.0
225.0

4.3
4.9
8.1
5.8
2.3
13.0
302.3

4.6
5.8
9.1
6.8
2.3
14.9
323.9

4.6
7.5
8.6
6.6
2.0
16.1
350.0

4.4
4.8
8.8
6.8
2.0
13.6
309.1

4.4
4.7
9.2
7.1
2.1
13.9
315.9

4.9
3.2
11.4
9.1
2.3
14.6
298.0

0.78
12.65
4.91
4.99
4.64
7.12

2001

2002

2003

2004

2005

2006

2007

Data Source: IMF, Global Financial Stability Reports , from 2002 to 2009.

However, the summer of 2007 witnessed the subprime loan crisis in
the US, and the monolines, which is financial guaranty providers in
the US, began to fall into financial distress in January 2008. Moreoverthe crisis deepened with the deep financial difficulty to Bear Stearns
in March, 2008 and the bankruptcy of Lehman Brothers in September,2008. Consequently, global stock prices tumbled, with total securities
values declining to approximately 117 trillion dollars in 2008, a major
drop as opposed to 145 trillion dollars in the previous year.

5In the US, the total value of stocks and debt securities from 2001 to2008 was more than three times of GDP except for in 2002 3 and 2008,
indicating the active trading at the capital markets. This ratio peaked
at 3.64 in 2007.
We may consider the rapid development of securitization as a factor
that led to the expansionary trend in securities-related assets. Fromthe beginning of the 2000s the securitized products, such as
asset-backed securities (ABS) 4 , mortgage-backed securities (MBS) 5 ,and collateralized debt obligations (CDOs) 6, had been issued in greatamounts. Although securitization flourished since the 1970s in US
capital markets, the nature of that activity changed dramatically inthe 2000s. The common method of securitizing a portion of loans heldby commercial banks up through the 1990s led to the tremendous
extension of the originate-to-distribute (OTD) model, which structures
originated loans presuming that they will be immediately sold.
In other words, loan originators aggressively expanded their loans,while securitizing those loans and sell them off to institutional
investors. These securitized financial instruments were then actively
traded in global financial markets, with some of them are secondarily
securitized, eventually becoming widely held among not only the US
domestic investors but also investors in many different countries.
One of the most popular types of the loans incorporated into thesesecuritized instruments was the subprime loans, a type of residential
loans offered to low-income persons. The securitized instruments that
The major drop in US and global stock market capitalization in 2002 can be
attributed to the IT bubble burst, which existed between the late 1990s and theearly 2000s.
4 Securities issued based on underlying cash flows from assets, such as credits
and real estates, which the firm separates from its normal operations for issuingthem.
5 A type of securities backed by a collection of residential or commercial
mortgage loans.
6 A type of asset-backed securities with underlying assets of large-scale
pecuniary claims, such as loans for government or enterprises and corporate or
government bonds.
3

6

included these subprime loans as a part of their underlying assets
were forced into devaluation due to the collapse of the housing bubble
and rapidly increasing subprime loan defaults, leading to the great
confusion of global financial capital markets.
Next, in the EU region, its total stock plus debt securities values set
against GDP reveal that the ratios are nearly similar levels to thoseseen worldwide, although they are lower than that in the US. The
annual average growth rate between 2001 and 2007 indicatesdouble-digit growths in both values of stocks and debt securities, withprivate debt securities seeing a notable growth of 18.8%. As can beseen from this situation, though the epicenter of the global financial
crisis was found in the US, the bubble-like phenomena were existing inEurope as well, that was why the US origin crisis spilled over to the
EU region immediately.
Lastly in Japan, the value of stocks and debt securities set against
GDP exceeded three times from 2003 to 2007. The ration in Japan was
higher than those seen in the EU and worldwide. However, the natureof this situation significantly differed from that of other regions. One
determinant of Japan’s high security value over GDP ratio was thatJapan’s GDP was stagnant during this period, with an additional
factor that the value of government bonds greatly exceeded GDP.
Indeed, this reflects serious fiscal conditions for the central and local
governments in Japan. Conversely, private debt securities comprised asmaller portion of the total securities, with the annual average growthrate between 2001 and 2007 at a fairly low level of 4.6% as opposed tothose in other regions.
The context surrounding this scenario in Japan is that theoriginate-to-hold (OTH) business model, whereby an originator
continues to hold a loan to maturity, was still the most mainstream
way of doing financial business. Securitization was only developed
within a limited framework, and the above-mentioned OTD model that
had spread across the US gained little footing in Japan. Figure 1
7

illustrates the recent trends in the loan securitization; the total of
normal and bad loans made liquid in the market was 10.8 trillion yen
in 2003, at a relatively high level of 2.65% of the total outstandingloans. However, these securitized amounts significantly declined
thereafter, with the total amounts in 2009 and thereafter only slightly
exceeding 2 trillion yen, comprising the only 0.5%–0.6% of the total
outstanding loans.
Figure 1

Securitization of Credited Loans in Japan

trillion yen

％

12

3

10

2.5

8

2

6

1.5

normal loans (lefthand axis)

4

1

securitized loans per
total toans(right hand axis)

2

0.5

non-performing
loans(left-hand axis)

0

0

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

fiscal year

Note: The bar graph totals all securitized credits, including designated cession of loan obligations,trusts, and loan participations.
The denominator of the line graph is outstanding loans for domestic banks and domestic
branches of foreign banks.
Data Source: Bank of Japan and Japanese Bankers Association

Until the early 2000s, the Japanese banking industry was obliged tohold a huge amount of non-performing loans and faced severe
management conditions 7. As a result, banks strived to reduce theirrisk burdens through the joint acts of securitizing not only the bad

7

For details, refer to Chapter 3 of Hanazaki (2008).

8

loans but also healthy loans. That is why the loan securitization was
relatively high levels in 2003.
The recovery of the real economy that followed would decrease theamount of newly emerged bad loans and also allow for progress in
disposing of existing bad loans and serving to improve banking
industry profitability. This implies that banks then became morecapable of bearing risks, leading to a substantially diminishedsecuritization of existing bad loans because of the losing significance in
expanding securitization. Compared with the US and the EU, the loan
securitization and the investment in securitized instruments in Japanwas extremely limited, which resulted in a corresponding limited
influence by the global financial crisis on the performances of Japan’s
financial institutions.
2.2 The Development of the Shadow Banking System
According to a report by the Financial Stability Board (2011), theshadow banking system is defined as “credit intermediation involving
entities and activities outside the regular banking system.” Since itexists outside the banking system, it is also outside of the scope of
official safety nets.
IMF (2014) offers a new definition of the shadow banking, which
focuses on fund raising activities; that is, the financing of banks andnonbank financial institutions through non-traditional liabilities
regardless of the entities. Based on this new definition, securitization
constitutes the shadow banking, because it is a kind of fund raising
activities, being conducted in some cases directly on balance sheet ofbank entities or in other cases indirectly through the use of the Special
Purpose Vehicle.
Including this new idea, the shadow banking has a wide variety ofdefinitions. It can be broadly understood as the system expanding
access to credit and supporting the functions of market liquidity,

9maturity transformation, and risk sharing as a complementary force totraditional banking.
According to IMF (2014), the shadow banking as broadly defined
above approximately constitutes one-fourth of the total financial
intermediations worldwide. Particularly, the shadow banking has thegreat presence in the US, the UK, and the Euro zone. To consider the
UK as an example, the amount of assets of the shadow banking
exceeded two times that of GDP in the mid-2000s, exceeding threetimes that of GDP in 2009 and thereafter. The US is the only nation
where the amounts of shadow banking assets have exceeded those of
the traditional banking sector in 2001 and thereafter. The ratio of
shadow banking assets set against traditional banking assets peakedat 2.2 in 2007. Although it declined in the following years, it has risen
once again to approximately 1.8 in recent years.
Figure 2 displays an overview of the shadow banking system in the
US. The grey background in the figure delineates the scope of the
shadow banking. Until 2007, the US financial system relied on
procuringfunds

securitization

throughthrough

repos

various(repurchase
types

of

agreements) 8

conduits.

Inandaddition,

investment trust instruments, such as money market mutual funds,
are supported by the substantial capital inflow through global excess
liquidity.
On the securitization aspect, mortgage originators aggressively
provided subprime mortgages supported by the housing bubble, whichwere securitized into residential mortgage-backed securities (RMBS)
that were further re-securitized into CDOs. Banks provided credit
guarantees and liquidity for structured investment vehicles (SIVs) anda type of conduit called asset-backed commercial paper (CP). Banks
Repos imply a buyback condition for the sale of bonds in the US (primarily
treasury bills). However, the pre-determination of price and interest rate
stipulations for the bonds means that this is essentially a short -term lending
with a collateral of the bonds themselves.
810

also provided short-term lending to mortgage originators. In addition,monolines 9, financial guarantors, provided credit insurances for losses
from asset-backed CP and SIVs utilizing securitized instruments.
Figure 2

The US Shadow Banking System

Deposits

Loans

L
E
N
D
E
R
S

Loans

BANKs
Money

Credit & liquidity puts
Securities

Super Seniors

RMBSs

CDOs

SIVs & ABCP

Money

Money
Credit insurance

Loans

Money

Monoline

Money

Money

Short-term funding
CP

Money

Money Market Mutual Funds

Non-bank home loan company

Loan

B
O
R
R
O
W
E
R
S

Source: IMF, Global Financial Stability Report, October 2014

Finally, the increase of defaults in the subprime loan market thatmanifested in 2007 led to a liquidity crisis in the markets for RMBS,
CDOs, and asset-backed CP as investors refused to maintain holdingsin those securities. Money market mutual funds also experienced runs
just after the Lehman shock.
As indicated by Ikeo (2013), the rise of the shadow banking system ispartly due to incentives for regulatory arbitrage. Since the formalbanking system is subject to various financial regulations, a bankinspection and supervision, etc., shadow banks detached from normalbanks were created in great numbers to dodge these restrictions.
However, Ikeo (2013) emphasizes beyond the perspective of evading
regulations that a significant aspect is also observed in the shadow
A “monoline” insurance company is dubbed because it handles only one
business, which is providing guarantees to financial liabilities, as opposed tonormal “multiline” insurers that handle a wide range of insurance businesses.
911

banking system in resolving issues of insufficient short-term safe
assets. This aspect would be regarded as a positive response towards
investor needs.
As implied by this point, the argument focused on only the shadowbanking system’s drawbacks would be unbalanced and unfair. However,
it is crucial to consider best practices to manage the shadow banking
system in the interest of the future of financial systems 10.
Figure 3

Basic Structures of Credit Default Swap (CDS)(Normal period )Investors

Premium (Guaranty)

Financial institutions

Protection purchasers

Protection

Protection sellers

Investment

Corporate bonds

Firms issuing corporate bonds(In times of credit events, a case of spot settlement )Investors

Corporate bonds

Financial institutions

Protection purchasers

Payments for bonds

Protection sellers

Default

Right of claim

Firms issuing corporate bonds

Ikeo (2013) argues that an advanced and evolved macro prudential policy
framework is necessary to produce an effective shadow banking system.
1012

2.3 The Swelling of Credit Default Swaps
A CDS is a type of over-the-counter derivatives designed to transfer
credit risk. Figure 3 displays the CDS structure. In transactions
without a CDS, investors in a corporate bond bear the credit risk
involved. When utilizing a CDS, regular pecuniary payments caninstead be traded off to purchase credit risk protection against thebond’s notional principal. And on the occurrence of a credit event 11 thefinancial institutions selling the protection purchase the bond inquestion from the protection buyer, via either the delivery of thereference bond at face value or cash settlement.
Although a CDS is a method for shifting the credit risk of thecompany issuing a corporate bond, its uses have spread beyond
companies alone to nations and government-related institutions andABS, MBS, and other securitized instruments. Furthermore, since a
CDS not only shifts credit risk but also reflects the probability of acredit event occurrence for the relevant entity through its price, we
understand that CDSs serve to reveal through their prices how market
players view the degree of credit risk for the relevant entities behindthose CDSs at any point in time.
Although we may consider a CDS as functioning similarly to credit
guarantees, fundamental differences also exist. Namely, in a guaranty
contract, the relationship between the claim and the obligation is
specified, and among creditors and debtors the entity receiving theguaranty is the creditor. When the relevant claim is transferred toanother entity, the guaranty contract is also transferred. For CDSs, incontrast, the relationship between the claim and the obligation is not
specified, and the credit risks of various economic entities, such as
A credit event is an issuing entity’s debt default, bankruptcy, or other suchsituations that affect the liability’s conditions.
1113

companies, nations and securitized instruments, are designed to be
traded on the CDS market. This allows for CDSs to not only function asa transaction for corporate bonds, as illustrated in Figure 3, but also to
simply “buy protection” without holding any of the underlying assets,such as a corporate bond. This also naturally allows for the reverse
activity of “protection sales” in a credit risk market for economic
entities and securitized instruments.
Together with CDSs’ above-mentioned characteristics of being not
restricted by the real demand principle and the advancements infinancial technology which enabled the quantitative valuation of credit
risk, speculative CDS transactions by hedge funds and financial
institutions grew enormously in the 2000s. According to BIS surveys,
this resulted in a rapid growth of CDS notional outstanding worldwide
in the 2000s, peaking at the end of 2007 at 58 trillion dollars (seeFigure 4). The global GDP of approximately 55 trillion dollars in 2007
suggests excessive swelling of CDSs.

Figure 4

CDS Notional Outstanding

USD, Trillions
70

60

50

40

30

20

10

0
2004

2005

2006

2007

2008

2009

2010

Data Source: BIS Quarterly Review

14

2011

2012

2013

2014

Executing

a CDS contract,the corporate bond investor,

or“protection buyer,” may have hoped to be released from the credit risk
at hand, but this does not always hold true. This is due to thecounterparty risk of the “protection seller” defaulting and not being
able to fulfill contractual duties even if a credit event was to occur.
In fact, as the severity of the subprime loan crisis deepened in thesummer of 2007 and thereafter, the RMBS that used the subprimeloans as underlying assets and the CDOs saw major devaluations in
the market; thus, the financial institutions that served as “protection
sellers” and hedge funds sustained great losses. In September 2008,
despite the US government’s neglect of the Lehman Brothers failure,
AIG, the biggest insurer in the US, which was practically falling into
bankruptcy, got relief from the US government. This was because AIG
was the largest seller of CDS protection during that time, and it was
believed that if AIG were to go bankrupt as Lehman Brothers, themarket for CDSs and other securities would be completely devastated.
As depicted in Figure 4, CDS notional principals peaked in 2007 andtrended downward thereafter, declining down to only 30% of its peak,or 16 trillion dollars, in 2014 12.
These CDSs, developed to transfer credit risk, were amplified as oneof the targets for speculative transactions in the formation of thefinancial bubble, and finally further exacerbated the financial crisis
resulting from the bubble’s collapse.

The premium paid for CDS protection is called the CDS spread. The five -year
spread listed at Markit iTraxx Japan (a credit index with a basket of 50 major
Japanese firms) trended at a high level since the subprime loan crisis surfacedin the summer of 2007 at 1% (100 basis points), then climbed to abnormally highlevels between the end of 2008 and the beginning of 2009 (from 3% to 5%). It
gradually declined after that point and is trending around 60 basis points as of
September 2015.
1215

2.4 Development of Financial Deregulation in the US
A striking background for the above mentioned expansion of
securitization, shadow banking, and CDSs in the 2000s is thedevelopment of financial regulatory reform in the US. This section
overviews the movements seen in that area.
The financial regulatory structure of the US was built by the
Banking Act of 1933 (the Glass–Steagall Act). This law, in recognition
that excessive speculation by the banking sector was one of thedeterminants of the Great Depression, intended to restrain the
speculative activities of the banking sector. More specifically, itprohibited commercial banks from participating in security-related
operations (underwriting and dealing in securities, etc.), established
the Federal Deposit Insurance Corporation, authorized the FRB to setbank deposit interest rate ceilings, and introduced other regulations
along with other related laws 13.
Federal financial regulations extended further to cover bank holding
companies 14 with the Bank Holding Company Act of 1956. This law inprinciple banned interstate banking operations and non-banking
operations for bank holding companies, and the Bank Holding
Company Act Amendments of 1970 provided fairly tight restrictions on
the scope of non-banking activities in which the unit bank holding
company may engage.

For more information about the details of the Glass–Steagall Act, seeHanazaki (1985); for more on the context leading up to its enactment, see Uzawa(2000).
14 In the US financial system, opening bank branches is an overall restrictedpractice, and many states utilize a unit banking system that wholly bans
opening bank branches. The bank holding company system arose in response tothese restrictions to provide similar effects as would be experienced by openingbank branches.
13

16

Table 2

Chronology of Easing Financial Regulations in the US since 1980

1980 Mar

Depository Institutions Deregulation andMonetary Control Act enacted

gradual abolishment of deposit interest rate ceilings and eased regulations on savings and loan associations (S&Ls) to
put them on similar scope of businesses as depository institutions.

1980 Nov

Easing of S&L capital adequacy regulationsFHLBB (Federal Home Loan Bank Board) lowered S&L required net work from 5% of total deposits to 4% andabolished S&Ls' broker deposit limitations.

1981 AugTax Reform Act enacted

Created powerful tax incentives for individuals investing in real estate, spurring the real estate boom that followed.

1981 Sep

Issuance allowed of income capital certificates

FHLBB approved issuance of income capital certificates (ICC) by financially troubled S&Ls as a method for raising net
worth.

1982 Jan

Further easing of S&L capital adequacy
regulationsFHLBB further eased prudential regulations on S&Ls, including lowering their required net worth from 4% to 3% of
total deposits.

1982 Apr

Abolished regulations on S&L stockholders

FHLBB abolished minimum required number of stockholders for S&Ls (previously more than 400 people with min. of
125 local residents). Acquiring S&Ls became easier as a result.

1982 Jul

Penn Square Bank failed

Oklahoma-based Penn Square Bank failed due to over-lending in the oil/gas industry. FDIC paid off insured deposits,
took over deposit operations for the bank for two years.

1982 Dec

Garn-St. Germain Depository Institutions Act
enacted

Expanded S&L operating scope, approved such activities as commercial mortgages of up to 40% of total assets,
consumer loans of up to 30%, and introduced Net Worth Certificate Program (NWCP), whereby FDIC buys net worth
certificates issued by depository-insured institutions to prop up capital account.

1982 Dec

Deregulation of state-chartered S&L

As state-chartered S&Ls were shifting in great numbers to federal certification, California and other states approved
limitless investment in any sort of business for state-chartered S&Ls.

1983 Nov

S&L capital adequacy regulations strengthened

FHLBB raised required net worth for newly certified S&Ls to 7%. This period marks the beginning of the FHLBB's shift
away from a deregulatory stance.

1984 May

Continental Illinois National Bank and Trust
Company failed

Chicago-based Continental Illinois National Bank failed under burdens of bad assets bought up from Penn Square andbad energy-related loans. Total assets held were $33.6 billion, the largest held ever at collapse. The FDIC took bailout
measures, including direct funds injection to keep the institution alive. The FDIC bore costs of $1.1 billion in handlingthe bank's failure.

1985

S&L crisis in Ohio and Maryland

S&L crises became apparent in Ohio and Maryland. The state deposit insurance funds run out.

1987

S&L crisis in Texas

Texas state economy fell into great disarray, with S&L failures happening in succession. Of the 20 most loss-inducing
S&L bankruptcies, 14 were at Texas-based institutions.

1987 Aug

Competitive Equality Banking Act enacted

Federal Savings and Loan Insurance Corporation (FSLIC), the organization in charge of S&L-related insurance,
approved $10.8 billion in new capital procurement. This was not nearly enough to deal with the enormous costs
incurred in processing failed S&Ls.

1988

Bank failures reached peak intensity

Bank failures, which had been growing during the 1980s, reached their peak; the number of cases with involvement by
the FDIC reached 279, the highest since the FDIC began operations in 1934.

1988 JulFirst Republic Bank Corporation failed

Dallas, TX-based First Republic Bank fell into insolvency due to downturns of the loans in energy, real-estate, andagriculture. Though the FDIC put bridge-bank procedures in place, the costs involved reached $3.9 billion, the highest
amount seen up to that point.

1989

S&L bankruptcies hit peak intensity

S&L bankruptcies reached a peak of 326, with a total of 533 bankruptcies between banks and S&Ls - exceeding 1988's
464 total bankruptcies.

1989 Aug

Financial Institutions Reform, Recovery, andEnforcement Act enacted

1991

Mergers/restructuring continued at majorbanks

1991 Feb

US Department of the Treasury announced
plan for financial system reforms

1991 Dec

Federal Deposit Insurance Corporation
Improvement Act enacted

Though this law was enacted in connection to the Department of the Treasury's reform plans, key items of the plan were
excluded, such as deregulation of bank operations and decreasing the scope of deposit insurance.

1992

S&L crisis peaked out

181 bank and S&L failures comprised a drop to approximately one-third the 1989 peak (533 failures), with the S&L
crisis heading toward its final days.

1995 Dec

RTC abolished

The RTC, established in 1989 to deal with thrift institutions that failed, finished its duties and was abolished at the endof 1995 . The RTC was involved in a total of 747 bankruptcy procedures comprising $420.6 billion in total assets.

1999 Nov

Gramm-Leach-Bliley Act enacted

A banking system for financial holding companies was established on top of the existing system for bank holding
companies, and cross entry into banking, security, and insurance businesses became possible. This law effectively
repealed the 1933 Glass-Steagall Act's separation of banking and security businesses.

In line with S&L handling measures announced by the G. H.W. Bush administration in February of the same year, thislaw abolished the FHLBB, transferred depositor insurance from the FSLIC to the FDIC and created a new supervisory
authority for S&Ls: the OTS (Office of Thrift Supervision). It also established a new RTC (Resolution Trust
Corporation) to handle disposal of failed thrift institutions.
Chemical Banking (merge between Chemical Bank and Manufacturers Hannover, July), Nations Bank (NCNB, C&S
Sovran merger, July), BankAmerica (BankAmerica and Security Pacific merger, August). Restructuring at Citicorp andothers.
This plan included drastic financial systemic reforms to cope with financial crises. Primarily, they included theintroduction of a risk-based deposit insurance premium, the reduction of deposit insurance coverage, the banksupervision based upon the subdivisions in capital adequacy ratios, and eased regulations on opening branchesinterstate.

17

This trend of tightening financial regulations drastically shifted
toward a deregulatory posture with the Depository Institutions
Deregulation and Monetary Control Act 15 in 1980. The regulatory
reforms established since this particular law can be viewed in Table 2.
These reforms, however, are not wholly of a deregulatory nature 16.
More specifically, the US experienced a savings and loan (S&L) crisis
starting in 1982 that bankrupted many financial institutions andresulted in toughened capital adequacy requirements imposed on
S&Ls (1983).
In 1984, because of the severe financial troubles happened in the US
such as the bankruptcy of its eighth-biggest bank, Continental Illinois
National Bank and Trust Company, the financial deregulation trend
temporarily halted. However, as the S&L crisis passed its worst daysin around 1992, deregulation gained momentum once again and theGramm–Leach–Bliley Act was enacted in 1999. This law created thefinancial holding company system, enabling banks to directly holdsecurities and insurance companies as their subsidiaries. This reformof the system effectively repealed the barriers of banking andsecurities established by the 1993 Banking Act 17.
As stated above, the bubble-like expansion in the US financial sector
and financial instruments was most striking after the beginning of the
2000s. Undoubtedly, the financial deregulation trend that began fromthe early 1980s and concluded with the enactment of the Gramm–
Leach–Bliley Act in 1999 was a driving force that helped expand thefinancial bubbles from a systemic standpoint.

This law follows precedent studies such as the Hunt Commission Report(1971), which emphasized the need for reform to realize a free and competitive
financial market, and the Financial Institutions and the Nation’s Economy(FINE) Study (1975), which proposed the abolishment of deposit interest rateceiling regulations and the expansion of savings financial institutions scope ofoperations. For more details, see Hanazaki (1985).
16 See Hanazaki (2000).
17 Securities operations by banks themselves continue to be prohibited.
15

18

3. Theory and Reality in Financial Regulations
3.1 Unique Nature of Banks and Rationale for Banking Regulations
The primary function of a bank is financial intermediation. Morespecifically, it fundamentally raises funds from entities with financial
surplus (excess saving) through a depository system and supplies those
funds to entities with financial shortage (excess investment) via a loansystem. In this process, the deposits are the bank’s liabilities, while
the loans are its credits.
Non-financial firms also have credits and liabilities; this is not aparticular characteristic limited only to banks. In addition, while bankclaims are primarily against companies, it is hardly a rare situation
for a non-financial firm to also have a large share of claims against
other companies; no fundamental difference also exists from thisperspective. The particularities of banks as opposed to those ofnon-financial firms are the counterparties of their liabilities. To be
more precise, non-financial firms’ liability counterparties often
comprise banks, other financial institutions, business partners, andrelated companies, whereas banks’ core liability counterparties areindividual small depositors.
In general, it would be preferable for the creditors to a bank tomonitor or intervene the bank management, if the creditors’ rights
were to be infringed upon by inappropriate management. However,small depositors do not have sufficient ability or incentive to gather
information about and monitor their bank’s management. The small
depositors are considered to be in a disadvantaged position owing to
the limitations of information gathering and protective measures.
Thus, prudential regulations against banks were deemed to benecessary, justifying the existence of a financial agency that could
monitor bank management or intervene during poor performance onbehalf of depositors (Dewatripoint and Tirole, 1993).

19

3.2 Origin of the Basel Regulations
As observed above for the US, financial regulatory systems inadvanced nations, such as the US, European countries, Japan, etc.,
were constructed on the basis of historical experience in banking
activities and the situation of the financial system in each individual
nation.
However, prompted by the development of international economic
activity based on the post-World War II IMF–GATT system, the 1970s
and thereafter saw active cross-border capital flows. Under suchcircumstances, the failures of US-based Franklin National Bank andsubsequently West Germany’s Herstatt Bank that surfaced in May andJune 1974 inflicted great chaos on international financial markets 18.
This chaos that emerged in international financial markets spreadthe awareness of a need for an international banking supervisorysystem; thus, the Basel Committee on Banking Supervision wasestablished in 1975, which held significant active discussions on the
topic. Following the experience of Black Monday (October 1987), it wasonce again recognized that international cooperation between financial
agencies was crucial; to that end, unified international standards forbank capital adequacy (BIS standards) were determined in July 1988.
Otherwise known as the Basel Accord, it imposed homogenous
competitive conditions on banks from various nations that wereinvolved in international banking operations, consequently seeking to
improve the soundness and stability of international financial systems.
In brief, this demanded that banks seeking to engage in international
Herstatt Bank entered into foreign exchange contracts with the US banks
whereby it would purchase Deutsche marks and buy US dollars; however, due tothe time zone difference between Germany and the US, it went bankrupt after
receiving the marks but before delivering the dollar payments. The US banks
that were its transaction partners suffered significant loss. The timezone-related exchange settlement risk seen herein has come to be called“Herstatt risk.”
18

20

operations should hold owned capital of at least 8% set against a total
asset value calculated with risk weighting.
This regulation, which subsequently came to be known as Basel I,
became effective at the end of 1992 for financial institutions frommajor nations that sought to run banking operations internationally.
3.3 Refinement of the Basel Regulations
In the initial Basel Accord, the credit risk of assets was the soletarget of regulation. The expansion of marketable asset transactions
by banks led to considerations of best practices to manage risks forfluctuations of interest rates, prices, and exchange rates for the assets
held by banks in trading accounts purposed for short-term arbitrage.
The resulting amendment to the Basel Accord, which commenced at
the end of 1997, added a capital charge for the amounts equivalent to
the market risks to the total risk-weighted assets when trading
accounts exceeded a certain amounts.
The expansion of newly developed securitized instrument trading on
the market in the 1990s as a result the progress of the financial
engineering also led to an increased need to evolve risk management
techniques for banks. The limitations of Basel I were recognized anddiscussions began anew at the Basel Committee on Banking
Supervision in the second half of the 1990s about new capital adequacy
regulations. After multiple public consultative proposals and hearings
from commercial banks and so on, the final text of Basel II was
published by the committee in June 2004, to commence in the period
following the end of 2006.
Basel II stipulates a new category of risk, called “operational risk 19,”that is added to the total risk-weighted assets; this simultaneously
permits broader ranges of risk weighting for each asset based on
The operational risk refers to the risk of operational accidents , system
malfunctions, fraudulent activity, or other loss-causing incident within afinancial institution.
19

21

creditworthiness, also enables banks to utilize internal credit rating
models for the calculation of credit risks. Furthermore the promotionof banks’ own efforts toward information disclosure and risk
management comprise a distinguishing feature of Basel II 20.

4. Financial Regulations after the Lehman Shock4.1 Situations in the US
The US government’s reaction to the Lehman shock was swift. On
October 3, 2008, not even three weeks after the bankruptcy of Lehman
Brothers, the Emergency Economic Stabilization Act of 2008 was
established. This law includes a measure for the government purchaseof troubled assets, such as financial instruments that incorporate
residential mortgages, securing a maximum budget of 700 billion
dollars for such purchases 21. This emergency step has been considered
to be effective in preventing a chain reaction bankruptcies of financial
institutions facing insufficient liquidity (Allen and Carletti, 2010).
Subsequently in June 2009, a financial regulatory reform proposal(titled “Financial Regulatory Reform—A New Foundation: Rebuilding
Financial Supervision and Regulation”) was publically announced by
the US Department of the Treasury. This reform proposed an
integration of the divided and complicated supervision system forfinancial institutions, a tightening of regulations on hedge funds,
securitized instrument markets, and CDSs; these items would later be
implemented as part of the Dodd–Frank Act.

See Hanazaki (2013) for more details regarding the development of the Baselregulations.
21 This swift response may well reflect the so-called “Fed View.” The Fed View,
which traditionally expresses the FRB’s basic stance on macroeconomic policy,
saw difficulty in controlling bubble phenomena through the monetary policy anda need for a swift reaction at the time of a bubble’s collapse. This view sta nds incontrast to the BIS view, which emphasizes a need for preventative measures tokeep bubbles from swelling.
20

22

Another occurrence that significantly impacted the world was a new
regulatory

proposal(titled“President

Obama

Calls

for

New

Restrictions on Size and Scope of Financial Institutions to Rein in
Excesses and Protect Taxpayers”) by US President Barack Obama on
January 21, 2010. This proposal was one primarily advocated by aformer FRB chair Paul Volcker (1979–1987), who was, at that time, theeconomic brains behind President Obama’s administration: this is
known as the “Volcker Rule.”
The Volcker Rule aims at setting limitations on commercial banking
operations in two ways. The first is to limit the operating scope; more
specifically, prohibiting a bank or a financial institution that contains
a bank from owning, investing in or sponsoring a hedge fund or a
private equity fund as well as from being involved in proprietary
trading operations unrelated to serving customers. The second imposes
limitations on size, and placing broader limits on the excessive growthof the market share of liabilities at the largest financial firms, tosupplement existing market share caps applied to deposits
Considering the influence wielded by financial liberalization in the
US (as mentioned in Section 2.4 of this paper) on the financial crisis
whereby the Lehman shock occurred, the Volcker Rule intended to casta regulatory net over banks’ excessive risk-taking behaviors. However,the process for institutionalization of the Volcker Rule had its ups anddowns. The context behind this turbulence comprises resistance fromcommercial banks claiming that profit-increasing opportunities would
be likely to shrink due to toughened market transaction regulations;this context complexly combined with the intent of regulatory agencies
to utilize this opportunity to improve banks’ internal control system.
After the determination that the general provisions of the Volcker
Rule were to be incorporated into the Dodd–Frank Act (to be discussed
below), a final set of regulations was approved and announced in
December 2013. Although bank proprietary transactions would bebanned by these regulations in principle, exceptions were set for banks
23that met certain terms, allowing them to engage in underwriting,market making activities, risk hedge-related transactions, andtransactions involving public bonds. In addition, although banks werebanned from directly and indirectly owning hedge funds or private
equity funds, approval for association with these was granted inaccordance with the satisfaction of certain conditions, if the funds
provided trust, trustee, or advisory services.
Thus the final regulatory form of the Volcker Rule swelled withexceptions, and there are deep-seated concerns whether it would
achieve its expected results in the end. However, this regulation also
included tougher compliance regulations for banks

and would

assuredly increase various related burdens and costs for banks. The
final approved regulations were fully enforced by July 2015.
4.2 The Dodd–Frank Act
The most major reform in the US financial regulatory system since
the Banking Act of 1933 (the Glass–Steagall Act) is the Dodd–FrankAct (Dodd–Frank Wall Street Reform and Consumer Protection Act),
established on July 21, 2010. The reason for the establishment of thislaw was the excessive risk-taking behavior by the financial sector thatserved as a factor causing the financial crisis that peaked with thecollapse of Lehman Brothers as well as the nonexistence of regulations
on

newfinancial

instruments,

such

as

CDSs

togetherwithinappropriate and insufficient supervisory structure for financial
institutions; the regulatory structure at the time was not considered tobe capable of protecting consumers and investors from suffering losses.
The enactment of this law concluded the aforementioned (Section2.4) financial deregulatory and liberalization trend of the 1980s and1990s. In contrast to the former deregulatory trend, it included various
important regulatory measures, such as the establishment of the
Financial Stability Oversight Council and Bureau of Consumer
Financial Protection, the Volcker Rule, restrictions on derivatives and24

securitization, and other tougher financial restrictions. Table 3
provides an overview of this law.
Table 3Main Contents of the Dodd–Frank Act

１．FSOC（Financial Stability Oversight Council） Established① Composed of 10 voting members (Secretary of the Treasury, FRB Chairman, Comptroller of
the Currency, FDIC Chairman, etc.) and five advising members② Identifies risk factors for entities, pushes market discipline to end "too big to fail," andremoves roadblocks toward financial system stability③ Applies prudential regulations for the systemically significant nonbanks (large-scale insurers
and securities firms, etc.)④ Introduces the OLA (Orderly Liquidation Authority) for insurers and nonbanks
２．Regulations on Private Fund Investment Advisors① Requires investment advisors to register with the SEC (excludes venture capital funds)
３．Volcker Rule
① Prohibits proprietary trading by banking entities (some exceptions for underwriting, marketmaking, hedging, and other transactions)② Prohibits banking entities from investing in or sponsoring a hedge fund or a private equity
fund, etc. (except for the cases that the investment amount is less than of 3% of fund asset size
and is below 3% of the bank's Tier 1 capital)
４．Regulations on Derivatives① Mandates CFTC (Commodity Futures Trading Commission) and SEC to regulate over-the counter derivative market transactions and market participation with respect to CDS andother such products② Implements swap push-out rule (banks must, on principle, engage in swaps with external
players) for all swaps (incl. security-based swaps)
５．Regulations on Securitization① In asset-backed securitization, a certain level of credit risk retention is required for
securitizing entities
６．BCFP（Bureau of Consumer Financial Protection） Established① Established within the Fed to regulate financial products/services for consumers and topromote information disclosure
７．Other① Introduces rigorous regulations on credit rating agencies② Sets restrictions on FRB emergency loans (supplying liquidity is permitted; bailouts are not)③ Corporate governance articles (strengthening shareholder rights, improving executive
compensation disclosure, etc.)25

4.3 Basel III
At the Basel Committee on Banking Supervision, drastic reforms to
the Basel regulations were discussed with respect to best practices torestore the soundness of the banking sector from the period just after
the Lehman shock.
As a result, the Basel Committee on Banking Supervision’s July2010 report and the agreement reached among its Group of Governors
and Heads of Supervision indicated a fundamental posture toward
capital adequacy requirements; more specific details were presented in
September 2010 in an agreement among the Group of Governors andHeads of Supervision. Discussions continued on regulations uponliquidity and other areas, and two kinds of documents were presented
by the committee in December 2010. This is so-called Basel III.
The fundamental awareness behind Basel III was that the crisis of
2007–2009

symbolized by

the Lehman shock,wascaused byinsufficient and/or lax financial regulations and that those regulations
needed to be rebuilt.
The core of Basel III is the toughening of capital adequacy
requirements. Although the calculation methods and composition
items used for capital adequacy ratios had been refined from Basel I to
Basel II, the required 8% ratio did not change. Accordingly, the natureof that capital was revised in Basel III as well as new regulatory items
were introduced, with this new regulation effectively raising capitalratios required overall.
More specifically, it limits core Tier 1 capital to common stock andinternal reserves (referred to hereafter as “common stock, etc.”), withthe minimum requirement raised to 4.5%. It, in principle, excludes any
capital gained by banks and other financial institutions trading
mutually among themselves to cosmetically inflate their capital.
However, for a bank investing in a financial institution outside thescope of accounting consolidation, if the bank had an ownership ofgreater than 10% of the target institution, then the investment portion
26

exceeding 10% of the Tier 1 common stock, etc. would be excluded fromthe bank’s capital. If the bank were to own up to a 10% share of theinstitution in question and its total ownership on the range of financial
institutions were to exceed 10% of the bank’s common stock, etc., thenthat excess portion would be excluded from the bank’s capital 22.
Basel III also makes the holding of a new 2.5% capital conservationbuffer in the form of common stock, etc. compulsory that can be broken
down during financial distress. Introduction of this buffer increases
the capital adequacy requirements to 7.0% of the total capital incommon stock, etc., raising Tier 1 and Tier 2 combined capitalrequirements to 10.5%. Furthermore, in complement to this capitalconservation buffer, a new countercyclical buffer has also been
implemented. This is a capital buffer designed to absorb the potential
losses suffered by banks during economic recession that follow
excessive credit expansion. This ratio is determined independently byeach nation’s financial authorities and can be set between 0% and2.5%23.
Basel III’s enhancement of capital adequacy requirements have been
implemented in phases since 2013 and are scheduled to be in full effectin January 2019.
4.4 Introduction of Macroprudential Policy
The global financial crisis that originated in the United States had arevolutionary effect on the state of policies for ensuring financial
systems’ stability. Specifically, before the crisis at hand, financial
authorities of major nations and international organizations tended tothink that achieving a secure financial system was feasible throughThis means that the double gearing that is frequently seen between Japanesebanks and life insurance companies would be counted toward the b ank’s capital
to some extent.
23 This also included a trial implementation of a simple leverage ratio for
capital adequacy requirements (a ratio of Tier 1 capital as a percentage of its
total on-balance sheet exposures).
22

27

the use of policies meant to bolster the soundness of individual
financial institutions (microprudential policy).
However, this crisis that many countries experienced have led to the
spread of an awareness thatmicroprudential

policyalone

isinsufficient to stabilize financial systems and that macroprudential
policy 24 is indispensable as well. A report by the FSB, IMF, and BIS(2011) characterized macroprudential policy as follows.
1) Macroprudential policy is designed to limit systemic risk infinancial market.
2) Macroprudential policy encompasses the financial system as awhole, including the interaction between the financial and the real
sectors.
3) Instruments

used

in

macroprudential

policyareprimarily

prudential tools calibrated to target the sources of systemic risk 25.
Systemic risks would cause external diseconomies manifesting in
financial markets and systems in the event of, for example, the failureof a major bank that significantly influenced the market. Therefore,
macroprudential policy exists to block channels from which external
diseconomies may arise and to prevent financial crises and to stabilizefinancial systems.
We may therefore understand that the liquidity regulations, thesecond pillar of Basel III, were introduced from the point of view ofmacroprudential policy. In the crisis period from 2007 through thebankruptcy of the Lehman Brothers, the formerly animated financial
markets

witnessed

extremely

rapid

contraction,andliquidity

procurement became a formidable problem. Then many banks faced adearth of liquidity, being forced to rely on the support of financial
The term “macroprudential policy” is not new, but in fact dates back to the1970s. See Okina (2010).
25 Details on the selection of policy tools in macroprudence can be found in
CGFS (2012).
24

28

authorities. In other words, the banking sector’s risk management waslax on liquidity issues, and liquidity regulations were introduced tocorrect such a problem beforehand.
Basel III provides for two new complementary liquidity standards.
The first standard is called the Liquidity Coverage Ratio, aiming toensure that a bank maintains an adequate level of unencumbered,high-quality liquid assets that can be converted into cash to meet its
liquidity needs for a 30 day under a significantly severe liquidity
stress scenario. This standard is defined as follows.
Stock of high-quality liquid assets
Total net cash outflows over the next 30 days

≧

100％

High-quality liquid assets are calculated by combining level 1 assets(cash, central bank reserves, marketable securities representing
claims on or claims guaranteed by sovereigns, central banks orinternational organizations, etc. that satisfy several conditions, suchas assigned a 0% risk-weight under the BaselⅡStandardised Approach,etc.) and level 2 assets (marketable securities representing claims on
or claims guaranteed by sovereigns or central banks, etc. that satisfy
several conditions, such as assigned a 20% risk-weight under the Basel
ⅡStandardised Approach, etc. ,corporate bonds and covered bondsthat satisfy several conditions; they can comprise no more than 40% of
the overall stock after at least a 15% haircut has been applied). The
denominator of the LCR is calculated via the difference of total
expected cash outflows (calculated by multiplying the outstandingbalances of various categories or types of liabilities and off -balance
sheet commitments by the rates at which they are expected to run off
or be drawn down) and total expected cash inflows (calculated bymultiplying

theoutstandingbalances of various

categories

ofcontractual receivables by the rates at which they are expected to flow
in up to an aggregate cap of 75% of total expected cash outflows).

29

The second standard is called the Net Stable Funding Ratio that
establishes a minimum acceptable amount of stable funding based on
the liquidity characteristics of an institution’s assets and activities
over a one year horizon. In particular, the NSFR standard is
structured to ensure that long term assets are funded with at least aminimum amount of stable liabilities in relation to their liquidity risk
profiles. It is specifically defined as follows.
Available amount of stable funding > 100％
Required amount of stable funding
The numerator above includes bank capital, preferred stock andliabilities with effective maturities of one year or greater, and portionsof non-maturity deposits and wholesale funding that would be
expected to stay with the institution for an extended period in a stressevent. The denominator is calculated as the sum of the value of theassets held and funded by the institution, multiplied by a specificrequired stable funding (RSF) factor assigned to each particular asset
type, added to the amount of the off-balance sheet activity multipliedby its associated RSF factor. The Liquidity Coverage Ratio has been
implemented in phases beginning in 2015, and the Net Stable Funding
Ratio is scheduled to be phased in gradually starting in 2018.
4.5 Systemically Important Financial Institutions
The Financial Stability Board (FSB) 26 , comprising financial
ministries, central banks and other financial supervisory authorities
from G20 nations, has continued to expound on the necessity of policies
effectively

preventing

moral

hazardofsystemicallyimportantfinancial institutions (SIFIs) since it was established in 2009.
The FSB is administered directly by the G20; it inherited the operations of
the Financial Stability Forum as of April 2009 and makes the offering of an
opinion on financial regulatory reforms, etc.
2630

Since the systemic risk expected to arise if a SIFI were to fall into afinancial distress would be a grave issue, FSB therefore concludes thatthe moral hazard problem of “too big, interconnected, or complex to fail”
would be easily provoked 27.
Therefore, whether bankruptcy procedures for failed SIFIs can besmoothly conducted to prevent moral hazard and avoid systemic chaos
is one of the most crucial issues from the viewpoint of macroprudence.
In an FSB report in October 2011 (Key Attributes of Effective
Resolution Regimes for Financial Institutions), the organization
addressed this problem by indicating the necessity of various aspects
regarding financial systems, such as making effective bankruptcy
procedures that do not burden the taxpayer, establishing closeinternational corporations for the issues relating to global activities of
SIFIs, and guaranteeing transparency and rapidity of the bankruptcy
procedures, etc.
In July 2011, the Basel Committee on Banking Supervisionpublished a consultative document on “global systemically importantbanks” (G-SIBs). On the document, G-SIBs were made subject toadditional capital requirements (surcharges) due to the enormous
levels of bad effects that their bankruptcies would exert. This
surcharge is between 1% and 3.5% depending on the importance ofeach G-SIB, to be met with Tier 1 Common Equity. However, 2.5% is
the current upper limit, with the surcharge to be applied in phases
starting on January 1, 2016, and will be fully established on January 1,
2019.
According to the Basel Committee on Banking Supervision, global
systemic importance should be measured in terms of the impact that a

The bailout of American International Group, Inc., the largest insurancecompany at that time, by the US government and FRB immediately after the
Lehman bankruptcy in September 2008 was a classic example of a bailout
decision because an organization was “too big, interconnected, or complex to
fail.”
27

31

failure of a bank can have on the global financial system and wi der
economy. The selected five indicators that define G-SIBs reflect thesize of banks, their interconnectedness, the lack of readily available
substitutes for the services they provide, their cross-jurisdictional
activity and their complexity. The Basel Committee is of the view thatthe number of G-SIBs will initially be 28 28.
The

FSB

is

furtheraimingtotask

G-SIBs

with

a

new

requirement—Total Loss Absorbency Capacity (TLAC). In the FSB
consultative document issued on November 10, 2014, the FSB proposesto achieve the availability of adequate loss-absorbing capacity for
G-SIBs in resolution by setting a new minimum requirement for TLAC.
TLAC is a combination of an 8% minimum requirement for equity
capital excluding the capital buffer stipulated by Basel III and eligible
liabilities. 29
The FSB proposes that a TLAC requirement be set within the rangeof 16-20% of risk-weighted assets (RWAs) and at least twice the Basel
III Tier 1 leverage ratio requirement. Though the TLAC is expected tosee revision going forward, presumption of the original proposal
becoming official regulation 30 would result in a required total
risk-asset ratio of 19.5% to 26% for capital and qualifying debt
holdings for G-SIBs, comprising TLAC (16%–20%), capital buffer(2.5%), and surcharge (1%–3.5%).

The list of G-SIBs is updated on a yearly basis; as of November 2015, 30
banks worldwide are on that list. Three Japanese banks are included in the list,
including Mitsubishi UFJ (1.5% surcharge), Mizuho (1.0% surcharge), and
SMBC (1.0% surcharge).
29 Eligible debt requirements: unsecured, issued by a bankrupt entity, with atleast one year to maturity, and subordinated.
30 According to the FSB as of November 2015, the TLAC is to be implemented inphases beginning on January 1, 2019.
28

32

5. Harmful Effects of Financial Regulations
As mentioned at the previous section, because of the financial
regulation reforms as represented by Basel III, the regulations tend
not only to widen but also to tighten. Can we, however, say that theoccurrence and severity of the financial crisis connected to Lehman
Brothers’ bankruptcy were solely due to lax or nonexistent financial
regulations? In other words, would stronger regulation prevent
reoccurrence of a crisis? My answer is “no.” On the contrary, theexistence of regulations and institutions may, in some ways, induce
crisis.
Let us first examine the harmful effects of capital adequacy
requirements, the most important financial regulations. The first issue
facing these is that of procyclicality. During periods of economic
recession or financial crisis, on the one hand, degradations in the
numerator of capital adequacy ratios are caused by increasing
amounts of nonperforming assets and falling profitability, thus banks
have to decrease total risk assets to maintain required capital
adequacy ratios by squeezing new loans or retracting a line of credit.
This process would then lead to make the economy worse. During
periods of economic expansion, on the other hand, banks’ own capitaltends to increase and they tend to have aggressive loan behaviors.
Therefore, greater economic expansion would be realized. This is thefundamental mechanism of procyclicality. In fact, the problem ofprocyclicality derived from the Basel capital adequacy regulations
would have exerted a negative influence from the post-Lehman
Brothers’ collapse of fall 2008 through to 2009, as the financial crisis
was transformed into the global economic crisis.
Many scholars and economists have already pointed out theprocyclicality issue. As a result of the Basel Committee on Banking
Supervision discussions for Basel III, requirements for capitalconservation buffer that can be broken down during financial distresswere realized. However, requiring capital buffers in Basel III and33

strengthening capital adequacy regulations implies that banks would
be forced to hold more costly capital, encouraging risk-taking
behaviors for banks, as will be stated later.
Rajan (2009), in recognition of the problems surrounding capital
buffers and in consideration of cycle-proof regulation (effective
regardless of any economic states), proposed the introduction of acontingent capital which is a kind of debt issued by banks that could be
converted into stock in times of crisis. Debt with equity characteristics,
in general, tends to provide advantages to investors when stock prices
are going up. However, debt such as contingent capital, which can beconverted into stock in times of crisis, would likely not be highly
attractive to investors unless the interest rate of that debt were to be
set rather high. That means issuing contingent capital would force thebank into higher funding costs. Moreover, if the introduction ofcontingent capital were to effectively decrease a bank’s risk of
insolvency, it could also then cause a negative impact upon thedisciplinary mechanism toward the bank management.
The second harmful effect caused by capital adequacy regulations isthat they would encourage risk-taking behavior by banks. As pointed
out by Hellmann, Murdock, and Stiglitz (2000), although capital
adequacy regulations do have the short-term effect of suppressing abank’s risky behavior, they decrease the bank’s franchise value 31 byforcing it to hold costly capital, which may lead to the bank’s risky
behavior in the long run. Eventually, capital adequacy requirements
introduced with the intention of guiding sounder bank management
may have the opposite effect and induce a bank’s risk-taking behavior,thus jeopardizing sound banking operation.
The third important issue with strengthening global financial
regulations is the intent to lay a strong and uniform net of regulations
The franchise value refers to net present value of a bank’s future earnings solong as a chartered bank continues to operate.
31

34

without consideration of the differences among the nations’ financial
systems.

Financialsystemscanbebroadlyclassified

intomarket-based system and intermediary-based system. And financial
systems in different countries at different eras may be diverse,
depending on the characteristics and preferences of firms andhouseholds that utilize financial services. In that sense, thesefinancial systems inherently possess extremely diverse sets ofcharacteristics, no matter how the globalization process may develop.
It is not likely that each country’s financial system would converge into
one single model; instead, it is more apt to retain country specificnatures.
Under the circumstances that the nature of financial systems varies
among nations, imposing rigorous and uniform capital adequacy
regulations worldwide on the pretext of maintaining the soundness
and stability of financial systems is assured to be an inefficientsolution. Moreover, as these regulations would impose significant
restrictions upon banking behaviors, there are concerns that they may
exert negative influences on the real economy.
The fourth bad effect of the current regulation and system ismark-to-market accounting. Generally speaking, the market price of afinancial product is the foundation of mark-to-market accounting andprovides a useful signaling function with regard to the behavior of
financial institutions and other market participants and the market
price itself influences their behaviors. During ordinary periods, thiscreates a positive cycle of information. However, if market prices were
to begin to go up, then the first increase would trigger aggressive
behaviors of market participants and lead to yet another increase inmarket prices, eventually resulting in an asset price bubble as prices
continue to go up. Conversely, in periods of crisis, such as the Lehman
Brothers’ shock, an initial fall in asset prices can cause negative
reactionsfromfinancial

institutions,

intensifying

that

price

decline(Plantin, Sapra, and Shin, 2005; Allen and Carletti, 2008;35

Adrian and Shin, 2010). In other words, the mark-to-market
accounting system exerts procyclical effects much like capital
adequacy regulations.

6. New Direction for Future Financial Regulations
Given the diversity of financial systems around the world, enhancing
their functionalities from a perspective of fairness and efficiency would
requirecorrecting

regulations

andsystemsthat

inducetheabove-mentioned issues of procyclicality and excess risk-taking. From
this standpoint, we would not be able to conclude that tightening theBasel Committee’s capital adequacy requirements worldwide would bea desirable direction for financial regulations.
By loosening global financial regulations, on the contrary, banks
would secure an enhanced degree of freedom in their activity. And eachcountry’s financial authorities should be responsible for identifying
long-term sustainability for financially troubled banks and in the
event

of

unsustainability

theyshouldprovidefor an orderly

liquidation procedure instead of falling into the trap of “too big to fail”.
This type of direction would appear more advantageous. On depositor
protection, though a deposit insurance system designed by eachcountryis

primarily

crucial,reviewisrequiredonpossible

improvements to these systems, such as the introduction of a variableinsurance premium system depending on the degree of bank soundness
and the levy of a certain percentage of deposit interest rates as apremium of the deposit insurance, etc.
A shift in emphasis from global regulations to local ones necessitates
discussion on how to handle G-SIBs. Most importantly, handling a
G-SIB’s bankruptcy is a critical and troublesome issue. As mentioned
before, G-SIBs currently have surcharges imposed upon them as partof capital adequacy ratios, ostensibly to add a layer of loss absorption.
However, the problem of adding further excess regulations to G-SIBs is36

compounded by the serious issue of regulatory unfair disparity
between banks identified as G-SIBs and those that are not.
In contrast, a more locally-focused regulatory system could well be apractical solution strategy. That is G-SIBs’ cross-border branches
should be incorporated into local subsidiaries and should be supervisedby the country’s regulatory authorities.
The various experiences generated by the US origin financial crisis
would be highly suggestive that the present state of financial
regulations requires drastic reexamination.

37

References[1]Hanazaki, Masaharu (1985), “Financial Liberalization and Deposit
Insurance Systems in the United States,” (in Japanese), Economics
Today , Vol. 6-3, Research Institute of Capital Formation, Japan
Development Bank.
[2]Hanazaki, Masaharu (2000), “A Chronology of Financial Crisis inJapan and the United States,” (in Japanese), Hirofumi Uzawa andMasaharu Hanazaki (eds.), Economics of the Financial System,
23-52, University of Tokyo Press.
[3]Hanazaki, Masaharu (2008), Corporate Governance and Corporate
Finance: An Informational and Institutional Approach , (inJapanese), University of Tokyo Press.
[4]Hanazaki, Masaharu (2013), “Financial System and Financial
Regulations after the Lehman Shock – A Critical Discussion of BaselIII”, (in Japanese), Masaharu Hanazaki, Masayuki Otaki andQuing-yuan Sui (eds.), Economic Analyses of Financial Systems andFinancial Regulations , 100-134, Keisoshobo.
[5]Horiuchi, Akiyoshi (1995), “‘Credit Order ’ as Institutional Capital”,(in Japanese), Hirofumi Uzawa and Morio Kuninori (eds.),
Economics of Institutional Capital , 17-43, University of Tokyo Press.
[6]Ikeo, Kazuhito (2013), “Financial Crisis and Market-based Indirect
Finance – an economic analysis of the ‘Shadow Banking System’,”(in Japanese), Masaharu Hanazaki, Masayuki Otaki andQuing-yuan Sui (eds.), Economic Analyses of Financial Systems andFinancial Regulations , 71-99, Keisoshobo.
[7]Okina, Yuri (2010), Financial Crisis and Prudential Policy , (inJapanese), Nikkei Publishing Inc.
[8]Uzawa, Hirofumi (2000), “Social Common Capital and Financial
Systems,” (in Japanese), Hirofumi Uzawa and Masaharu Hanazaki(eds.), Economics of the Financial System, 1-22, University of Tokyo
Press.
[9]Adrian, Tobias and Hyun Song Shin (2010), "Liquidity andleverage," Journal of Financial Intermediation , Vol. 19, Issue 3,
418-437[10]Allen, Franklin and Elena Carletti (2008), "Mark-to-Market
Accounting and Liquidity Pricing," Journal of Accounting andEconomics, Vol. 45 Issue 2-3, 358-378.
[11]Allen, Franklin and Elena Carletti (2010), "The Global Financial
Crisis," Banco Central de Chile Working Papers No. 575.
[12]Committeeonthe
GlobalFinancial
System(2012),

Operationalising the Selection and Application of Macroprudential
Instruments , Bank for International Settlements, December.

38

[13]Dewatripont, Mathias and Jean Tirole (1993), The Prudential
Regulation of Banks, MIT Press.
[14]Financial
Stability
Board(2011a),Shadow
Banking:
Strengthening Oversight and Regulation , 27 October.
[15]Financial Stability Board (2011b), Key Attributes of Effective
Resolution Regimes for Financial Institutions, October.
[16]Financial Stability Board, International Monetary Fund, and Bankfor International Settlements (2011), Macroprudential Policy Tools
and Frameworks Progress Report to G20 , 27 October.
[17]Hellmann, Thomas F., Kevin C. Murdock and Joseph E. Stiglitz(2000), “Liberalization, Moral Hazard in Banking, and Prudential
Regulation: Are Capital Requirements Enough?” American
Economic review, 90(1), 147-165.
[18]International Monetary Fund (2014), Global Financial Stability

Report: Risk Taking, Liquidity, and Shadow Banking: Curbing
Excess While Promoting Growth, October.
[19]Plantin, Guillaume, Haresh Sapra, and Hyun Song Shin (2005),"Marking to Market, Liquidity and Financial Stability," Monetaryand Economic Studies, Vol. 23, No. S-1, 133-164.
[20]Rajan, Raghuram G. (2009), "The Credit Crisis and Cycle-Proof
Regulation," Federal Reserve Bank of St. Louis Review,
SEPTEMBER/OCTOBER 2009 Vol. 91, No. 5, Part 1, 397-402.

39

i[Profile: Masaharu Hanazaki]
Graduated from the School of Political Science and Economics, Faculty of Political
Economics, Waseda University in 1979. Worked at the Development Bank of Japan’s
Research Institute of Capital Formation and Research Department, the OECD’s
Economic Analysis and Statistics Division, The Brookings Institution, Hitotsubashi
University’s Institute of Economic Research, and Director-General of theDevelopment Bank of Japan’s Research Institute of Capital Formation. In his c urrent
position since April 2012. Holds a Ph.D. in Economics from Waseda University.
Major works include:•Koporeto gabanansu [Corporate Governance] (Iwanami Shoten, 2014)•Nihon keizai: Henkakuki no kinyu to kigyo kodo [Japan’s Economy: Finance andCorporate Behavior in Changing Times] (co-author and co-editor) (University ofTokyo Press, 2014)•Kinyu shisutemu to kinyu kisei no keizai bunseki [An Economic Analysis of Financial
Systems and Financial Regulations] (co-author and co-editor) (Keiso Shobo Publishing,
2013)•Kigyo kinyu to koporeto gabanansu [Corporate Finance and Corporate Governance](University of Tokyo Press, 2008, winner of the 50th Economist Award)

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