9 capital and liquidity requirements, under Basel III, and the FSB has developed an impressive agenda of reform. New legislation has been passed or is being prepared also at the national level.<sup>13</sup> This section discusses some of the challenges and outstanding issues in the reform agenda, focusing on the incentive distortions highlighted during the crisis.

Many of the elements of the Basel and FSB reforms are sensible and might help in reducing the build-up of vulnerabilities. This includes measures to improve transparency and risk management, curb excessive risk-taking by requiring more and higher quality capital and requiring liquidity buffers, aiming to reduce “too big to fail” subsidies by authorizing regulators to seize and wind down insolvent financial firms; and trying to reduce procyclicality by introducing countercyclical buffers. These reform initiatives, if properly implemented, may go some way towards addressing the incentive breakdowns highlighted in the run-up to the crisis.

There are, however, important challenges that still remain. These relate to issues such as increasing complexity of the regulatory framework, the need for flexibility, and supervisory resources and capacity, which we will discuss in more detail in the remainder of this section. Ultimately, these challenges lead to a risk of not adequately addressing the underlying incentive distortions.

# **_Challenges related to regulatory complexity_**

For regulations to be incentive-compatible and enforceable, they need to be relatively simple. This does not mean that all simple regulations are good, of course. But if regulations become too complex, their enforcement becomes more costly and less transparent, decreasing credibility and accountability. Complex regulations are also hard to understand for market participants and other stakeholders, weakening market incentives and discipline. Also, complex regulations create more opportunities for special interests to create loopholes, further weakening the effect of the regulation. In regulation, less complexity can often mean more in terms of results.<sup>14</sup> One problem with the recent regulatory reforms is that they have been leading to ever more complicated regulations. In the case of the United States, for example, numerous observers have pointed out the great complexity of the regulation introduced during the crisis.<sup>15</sup> Also in a broader sample of countries covered by the World Bank’s Banking Regulation and Supervision survey, it is correct to say that regulatory complexity has been on the rise, with even many small, low-income jurisdictions opting for relatively complex

> 13 Čihák, Demirgüç-Kunt, Martínez Pería, and Mohseni-Cheraghlou (2012) provide an update on regulatory developments in individual countries based on the World Bank’s Banking Regulation and Supervision survey. World Bank (2012) overviews the global regulatory response, focusing on Basel III and FSB reforms. 14 For a broader discussion on simplicity versus complexity, see for example Maeda (2009).

> 15 For example, The Economist (2012a) pointed out that at 848 pages, the Dodd-Frank law of 2010 is “longer, less intelligible, more incomplete than any other financial reform that was ever passed into law in the US”.