Queen Mary University of London, School of Law

Legal Studies Research Paper No. 100/2012

LEGAL AND REGULATORY RESPONSES

TO THE FINANCIAL CRISIS

Rosa M. Lastra

Electronic copy available at: http://ssrn.com/abstract=2020553

LEGAL AND REGULATORY RESPONSES TO THE FINANCIAL CRISIS

By Professor Rosa M Lastra1

Introduction

‘Never let a good crisis go to waste’, this phrase that the former chief of staff of US President
Barak Obama, Rahm Emmanuel, coined in response to the crisis, has been used in a variety
of contexts in the last three years. It encapsulates the policy, regulatory and political need to
do something, to respond to the popular (or populist) demand for regulation. Never again is
the slogan that policy-makers and politicians have often uttered in response to the worst
global financial crisis since the Great Depression.2

While there is consensus as regards the magnitude and severity of the crisis, there are
contrasting – even opposing views – with regard to the understanding of the causes of the
crisis and the types of regulatory responses that can best tackle the imbalances that were at its
root and to fix the problems of the financial system.

In an article with Geoffrey Wood,3 we looked at the multiple causes of the crisis and we
divided the regulatory responses into five groups:

– 1 – What to regulate

– 2 – Who regulates and how to regulate and the intensity of supervision

– 3 – Bankers’ behaviour, corporate governance, risk management

– 4 – Fiscal side and compensation

– 5 – Structural reforms

In this paper I survey some of these responses following this template (in particular 1 and 2)
and looking at developments in the US, UK, EU and internationally.

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1
Professor Rosa Lastra is Professor in International Financial and Monetary Law at the Centre for Commercial
Law Studies, Queen Mary University of London. Email: r.lastra@qmul.ac.uk
2
For an excellent historical analysis, see Carmen Reinhart and Kenneth Rogoff, This Time is Different: Eight
Centuries of Financial Folly, Princeton University Press, 2011.
3
Rosa Lastra and Geoffrey Wood, “The Crisis of 2007-2009: Nature, Causes and Reactions”, Journal of
International Economic Law, Vol. 13, No. 3 (Special Issue on the Quest for International Law in Financial
Regulation and Monetary Affairs), September 2010, pp. 531-550. See generally the introduction and
contributions to this Special Issue which I co-edited with Professors John Jackson and Thomas Cottier. Out of
this Special Issue a book will be published by Oxford University Press: International Law in Financial
Regulation and Monetary Affairs and this paper also draws on the draft conclusions to this book. Earlier
versions of this paper have been presented at a conference in Paris at the OECD on ‘Crisis Management and the
Use of Government Guarantees’ in October 2011 and a ESRC-NIESR conference on ‘Financial Stability’ in
London in February 2012.

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Electronic copy available at: http://ssrn.com/abstract=2020553

By way of introduction I would like to make three points. The first is that regulators often
fight the last war; responses to crisis are by definition ex post. This combined with a degree
of ‘regulatory fatigue’ is a useful reminder of the limits of regulation. The second is that we
need international rules for global markets and much more effective cooperation amongst
national authorities. Inconsistent or uncoordinated national responses are inadequate in the
presence of international financial markets. The modus operandi of central bankers is an
example for politicians and treasury officials of a model of effective international
cooperation. The third point is a wider philosophical reflection that concerns capitalism and
its critics. The logic of capitalism requires that both gains and losses be privatised. The idea
embedded in the too-big-to-fail doctrine (and its variants) that losses should somehow be
socialised runs against this logic.

1. What to regulate

The ‘what to regulate’ refers both to the type of entities or institutions that should fall
under the regulatory perimeter and, once this decision is taken, the type of measures
or rules that will limit risks with regard to the lending or investment decisions
institutions make and with regard to the lines of defences that the institution should
erect (typically in terms of capital and liquidity requirements) to withstand a crisis,
with the aim to minimise costs to society and to taxpayers.

The ‘what to regulate’ has triggered a multiplicity of rules (or proposed rules) for
capital, liquidity and other indicators of banking and financial soundness. In the
aftermath of the crisis, it is clear that banks had too little capital, too thin a buffer to
absorb losses and that the rules were therefore inadequate. Basel III is an attempt to
respond to the limitations of Basel I and II4. As an international standard it should
contribute towards establishing a level playing field. However, some ‘fault lines’ are
already apparent, since some countries will prescribe differential capital rules.
Furthermore, capital regulation is no panacea. Good banking and finance also rest
upon asset quality, management (including compensation and other incentives),
adequate earnings and risk controls.

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4
The Basel Committee on Banking Supervision, ‘Basel III: A global regulatory framework for more resilient
banks and banking systems’, December 2010, http://www.bis.org/publ/bcbs189_dec2010.pdf. The Basel
Committee on Banking Supervision, ‘Basel III: International framework for liquidity risk measurement,
standards and monitoring’, December 2010, http://www.bis.org/publ/bcbs188.pdf. The Basel Committee
subsequently conducted a review resulted a small modification of the credit valuation adjustment, and published
the revised version of the Basel III capital rules in June 2011. The Basel Committee on Banking Supervision,
‘Basel III: A global regulatory framework for more resilient banks and banking systems’, June 2011,
http://www.bis.org/publ/bcbs189.pdf. The core aspects of Basel III are scheduled to be implemented into
national law by January 1, 2013; certain aspects of the new standards are slated to become effective upon
implementation while others will be phased in over several years in between 2013-2019. In terms of liquidity
standards, after an observation period beginning in 2011, the Liquidity Coverage Ratio (LCR) will be introduced
on 1 January 2015 and Net Stable Funding Ratio (NSFR) will move to a minimum standard by 1 January 2018.

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Electronic copy available at: http://ssrn.com/abstract=2020553

 There is a perception that banks have already influenced the Basel III rules (‘hijacked’
the process?) given the long implementation period for the new capital regime. One
could be forgiven for thinking that we will be in Basel IV before reaching Basel III –
thus repeating the history of Basel II — an agreement that was itself never fully
implemented.

A more relevant question is why should capital requirements be strictly imposed upon
commercial banks (credit or depositary institutions) when the ‘shadow banking
system’ is engaged in similar types of risky activities?Moreover, emphasis on
capital, important as it is as an indicator of soundness, should not be the sole tool in
the regulators’ armoury. As Robert Litan insightfully stated in the 1980s, regulators
focus so much upon capital requirements because it is difficult to assess and control
the quality of the asset portfolio, and, of course, potential mismatches between the
duration of liabilities and assets provides a cause for concern about liquidity
management and controls.

In addition to the capital rules, the Basel Committee has been busy issuing new soft-
law rules. For example, the new ‘Core Principles for Effective Banking Supervision’
were issued for consultation in December 20115, addressing issues such as corporate
governance, the treatment of systemically important nanks, recovery and resolution
plans, which were not included in the original 1997 document. For its part, the
Financial Stability Board has also been publishing a number of principles and
documents, the most relevant being the ‘Key Attributes of Effective Resolution
Regimes for Financial Institutions’ published on 4 November 2011. 6 These key
attributes – which are the result of work undertaken by the FSB jointly with its
members including the IMF, World Bank and the standard-setting bodies – are
considered new internationally-agreed standards that lay out the responsibilities,
instruments and powers that national resolution regimes should have to resolve a
failing SIFI (systemically important financial institutions). They also establish the
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5
The Basel Committee on Banking Supervision, ‘Core Principles for Effective Banking Supervision:
Consultative Document’, December 2011, http://www.bis.org/publ/bcbs213.pdf. This document updates the
Core Principles and the associated Core Principles Methodology and merges the two documents into a single
comprehensive document. The Consultative document has increased the number of Core Principles from 25 to
29, introduced 36 new assessment criteria comprising 31 new essential criteria and 5 new additional criteria, and
upgraded 33 additional criteria from the existing assessment methodology to essential criteria that represent
minimum baseline requirements for all countries. Moreover, it has reorganized the revised set of twenty-nine
Core Principles to foster their implementation through a more logical structure commencing with supervisory
powers, responsibilities and functions, focusing on effective risk-based supervision, and the need for early
intervention and timely supervisory actions and followed by supervisory expectations of banks, emphasising the
importance of good corporate governance and risk management, as well as compliance with supervisory
standards. The revision aims to address many of the significant risk management weaknesses and other
vulnerabilities highlighted in the last crisis. It also responds to several key trends and developments that
emerged during the last few years of market turmoil: the need for greater intensity and resources to deal
effectively with systemically important banks; the importance of applying a system-wide, macro perspective to
the micro-prudential supervision of banks to assist in identifying, analysing and taking pre-emptive action to
address systemic risk; and the increasing focus on effective crisis management, recovery and resolution
measures in reducing both the probability and impact of a bank failure.
6
http://www.financialstabilityboard.org/publications/r_111104cc.pdf

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 requirements for resolvability assessments and recovery and resolution planning for
global SIFIs, as well as for the development of institution-specific cooperation
agreements between home and host authorities. They are aimed at solving the too-big-
to-fail problem by making it possible to resolve any financial institution in an orderly
manner and without exposing the taxpayer to the risk of loss, protecting essential
economic functions through mechanisms for losses to be allocated between
shareholders and unsecured and uninsured creditors.

Whether these legal and regulatory changes will help prevent the next crisis remains
to be seen. Historical experience suggests that regulation is not a ‘natural’ product,
but a by-product or reaction to crises or conflicts. Regulation is most needed in good
times, when rapid credit expansion and exuberant optimism cloud the sound exercise
of judgment in risk management, yet regulation is typically designed in bad times, in
response to a crisis. We need appropriate counter-cyclical regulation, bearing in mind
the biblical story of Joseph in which provisions were gathered in good times to be
used in bad times.7

With regard to the scope of institutions that should be regulated, Andrew Crocket8
advocates the need to ‘widen the net’ beyond the three pillars upon which financial
regulation has traditionally rested (i.e., banking, securities and insurance) to a wider
range of institutions that are now central to the safeguarding of financial stability,
such as those involved in the originate-to-distribute model of credit intermediation,
service providers such as clearing and settlement systems, credit rating agencies and
auditing firms, and private pools of capital such as hedge funds and private equity
funds. Perhaps the answer in some cases – e.g., with regard to derivatives markets – is
not more regulation, but more transparency and accountability, a well functioning
clearing system, and on balance sheet accounting treatment. In some other cases, the
answer will be litigation.9

2. Who regulates and how to regulate – the intensity of supervision

All national ‘architectures’, whether one authority, twin-peak, or many regulators,

failed to prevent the crisis (Garicano and Lastra, 2010)10. Hence, changes in structure
are unlikely to lead per se to a better system of supervision. The failure was not in the

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7
See Charles Goodhart and Rosa Lastra, ‘Border Problems’, Journal of International Economic Law, Vol. 13, No.
3, September 2010, pp. 705-718.
8
See Andrew Crocket, ‘Rebuilding the Financial Architecture’, (2009) 46(3) Finance & Development 18-19, at
18.
9
See Charles Goodhart and Rosa Lastra, ‘Border Problems’, Journal of International Economic Law, Vol. 13, No.
3, September 2010, pp. 705-718.
10
Luis Garicano and Rosa Lastra, ‘Towards a new Architecture for Financial Stability: Seven Principles’, Journal
of International Economic Law, Vol. 13, No. 3, September 2010, pp. 597-621.

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 ‘who’, but in the ‘how’ to supervise and in the priority given to the objective of
financial stability.

This notwithstanding, the UK government has yet again introduced fundamental

structural changes, establishing a new supervisory architecture with the following
components: (1) A Financial Policy Committee (FPC) in the Bank of England, with
primary statutory responsibility for maintaining financial stability across the financial
system using macro-prudential tools to ensure that systemic risks to financial stability
are dealt with; (2) A Prudential Regulation Authority (PRA), a subsidiary of the Bank
of England, responsible for prudential regulation of all deposit-taking institutions,
insurers and investment banks; and (3) a Financial Conduct Authority (FCA) with a
primary statutory responsibility to promote confidence in financial services and
markets.11

While the return of the Bank of England to a financial stability mandate to be pursued
in tandem with its price stability mandate is a welcome development, I am much less
persuaded by the wisdom of the proposed structural changes. I am also concerned
about issues of co-ordination — which, if anything, have become more relevant and
problematic given the multiplicity of authorities — and about issues of accountability.
The Bank of England has a clear mandate with regard to monetary policy, and since
the Banking Act of 2009, it has also had a mandate for financial stability as well as
crisis management responsibilities (the Special Resolution Regime) to deal with
troubled banks. With the new changes, the supervisory powers of the Bank of
England will be substantially expanded both with regard to macro-prudential
supervision through its new Financial Policy Committee and to micro-prudential
supervision through the Prudential Regulation Authority. As the Treasury Select
Committee concluded in its inquiry in July 2011, there are serious concerns about the
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11
See http://www.hm-treasury.gov.uk/press_08_12.htm The Government published the Financial Services Bill
on 27 January 2012. The Bill:

• Gives the Bank of England responsibility for protecting and enhancing financial stability, bringing together
macro and micro prudential regulation;
• Abolishes the Financial Services Authority (FSA) and creates a strengthened regulatory architecture
consisting of the Financial Policy Committee, the Prudential Regulation Authority and the Financial
Conduct Authority, also providing them each with clarity of responsibility and the necessary powers to
ensure the stability of the financial sector and the protection of consumers; and
• Empowers authorities to look beyond ‘tick-box’ compliance and fosters a regulatory culture of judgment,
expertise and proactive supervision.
• Today’s Bill has been shaped by extensive consultation with both stakeholders and Parliament and, while the
fundamental elements of the new framework are in line with the model put forward by the Chancellor in
2010, contains a number of refined policy proposals, including measures to:
• Legislate for a new crisis management regime, providing greater clarity and accountability to protect the
taxpayer during times of crisis by providing the Chancellor with new powers over the Bank of England
where public money is at risk; and
• Enables the transfer of responsibility for regulating consumer credit to the Financial Conduct Authority to
better protect consumers.

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 accountability of the revamped Bank of England.12 With power comes responsibility
and accountability (Lord Acton’s dictum resonates in the background of the corridors
of power, as a key reminder of the importance of accountability).

When it comes to objectives and their prioritisation, it is widely accepted that the
neglect of financial stability prior to the crisis was one of its causes. As a response,
the concept of macro-prudential supervision is now embraced by financial authorities
in the EU, UK, US and other jurisdictions. (Macro prudential supervision is
analogous to the oversight of the forest, while micro prudential supervision is
analogous to the oversight of individual trees).

The comparative experience is useful to get a sense of perspective. For example,

while the FSA is going to be dismantled in the UK, in the US there have been calls ‘to
end the Fed’ (the title of a book by Republican candidate Ron Paul). The US has re-
designed its financial regulatory system through the enactment of the Dodd-Frank
Wall Street Reform and Consumer Protection Act, though in the end the changes were
relatively minor when it comes to structural issues.13 (The Act creates the Bureau of
Consumer Financial Protection and abolishes the Office of Thrift Supervision,
distributing its powers among the Federal Reserve System, the Office of the
Comptroller of the Currency and the Federal Deposit Insurance Corporation (FDIC).
Even after the Dodd-Frank Act, the US financial architecture remains fragmented and
‘multi-peaked’. Its complex regulatory system is still based upon a combination of
federal law (financial laws enacted by Congress), state law, regulation by agencies
(the Fed and the Securities and Exchange Commission have rule-making powers), and
self-regulation (in the field of securities, the rules of the self regulatory organizations).
One significant change introduced by Dodd-Frank is the establishment of a Financial
Stability Oversight Council (chaired by the Secretary of the Treasury and with
representation from all the regulatory agencies) to identify risks to financial stability
that could arise from firms and markets and to respond to emerging threats to the
stability of the US financial system. The central bank has also expanded its remit,
since the Fed’s supervisory power can be extended to non-bank systemically
significant financial firms. And under the orderly liquidation authority regime, the
FDIC can be appointed as a receiver for systemically important financial institutions
(SIFIs).

In the EU, bank regulation presents a rather unified framework, following the
adoption of a substantial number of Directives and some Regulations . In terms of
supervision 14micro-prudential supervision is a national competence, albeit subject to
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12
Twenty-first Report of Session 2010-12, Accountability of the Bank of England (HC 874).
13
Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203 (2010) (the Dodd-Frank Act).
14
Regulation refers to the establishment of rules, to the process of rule-making. Rules can be national,
supranational and international, private as well as public, hard law and soft law. International rules suffer from
the ‘eternal’ problem of international law: its effective enforcement. These problems are exacerbated by the fact
that most international financial rules are ‘soft law’ rules and therefore an effective system of sanctions is
typically absent. While regulation refers to the establishment of rules, supervision (micro supervision) refers to

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 increasing federalisation through the European Supervisory Authorities (ESAs), while
macro prudential supervision is a task entrusted to the ESRB, though the ECB and
national central banks (NCBs) are also competent to decide on issues of financial
stability. This can pose problems or tensions in particular with regard to non-eurozone
NCBs. Financial stability is the ultimate goal of supervision, regulation and crisis
management. It is a national, a European and an international goal and it is a goal that
transcends institutional boundaries.

The model of the ESAs (see chart at the end of this paper) is not in my opinion the
best one to organise EU financial supervision. What Europe needs in banking and
finance should be modelled – mutatis mutandis – to what Europe has in football:
namely national players playing under national leagues and European players playing
under UEFA rules. A ‘Champions league’ model of supervision would be also be
suited for crisis management in the EU. As acknowledged, crisis management in the
EU is still subject to complex EU rules on state aid (competition policy) and a
‘patchwork’ of Directives & regulations that govern banking and financial markets
(bewildering complexity), though a Draft Directive on Crisis management – bringing
a degree of consistency to this field - should be published soon.

In response to the crisis, two trends can be identified: first, a reinforcement of the role
of the central bank and, second, because of the fiscal costs of the bailout or rescue
packages, greater political interference and reduced independence for central banks
and supervisory agencies. This latter trend is in stark contrast with the movement
towards independence that characterised the framework of central banks prior to the
crisis.

What I find somewhat puzzling is the inadequate response in the UK and elsewhere to
the key challenge: the dichotomy between national law and global markets. The
reshuffling of supervisory responsibilities per se does not take away the fundamental
problem, which is the ‘illusion’ of relying upon national regulation and supervision to
confront the challenges of international markets and globalization. There are two
extreme solutions: the retrenchment to national law and structures (de-globalization)
and the internationalisation of rules and structures.

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the oversight of financial firms’ behaviour, in particular risk monitoring and risk control. Supervision (micro-
supervision) in a broad sense can also be understood as a process with four stages or phases: first, licensing,
authorisation or chartering (entry into the business), secondly, supervision stricto sensu (the essential component
of any supervisory process), thirdly, sanctioning or imposition of penalties – both institutional and personal - in
the case of non-compliance with the law, fraud, bad management or other types of wrongdoing, and, finally,
crisis management, which comprises lender of last resort, deposit insurance, bank insolvency proceedings and
other implicit or explicit measures, including guarantees and different rescue packages. While risk control
provides the link between supervision and management, enforcement and compliance provide the link between
effective supervision and regulation. For a further elaboration of these four stages with regard to banking
supervision, see Rosa Lastra, Central Banking and Banking Regulation 108-144 (1996).

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 Luis Garicano and I advocate the need for an ‘international financial architecture’. 15
In our view, given the rise in systemic risks noted by all the reports on the current
system and the interconnectedness of the global financial system, the way forward
must involve the substitution of this loose network with some hierarchical structure
more akin to the one used in the WTO. That is, in the same way as the governance of
trade has required a new multilateral organ with a clear, hierarchical structure that has
superseded the previous morass of bilateral relationships, the evolution of the
financial system requires the creation of a new multilateral financial body with
authority to settle disputes and to impose its decisions. We need a forum to bring
disputes when standards (e.g., capital rules) are not observed. In the field of
international finance we need to devise appropriate mechanisms for the settlement of
financial disputes.

The challenge posed by the dichotomy between global markets and national law is
best exemplified by the problems posed by the resolution of cross-border systemically
important financial institutions, for which living wills may provide an answer.16

3. A third group of proposals concerns incentives, the behaviour of the banking

industry and bank management, whether through better risk management, better
corporate governance, or simply through the responsibility that comes with the
banking job and the need to internalize the costs of protection.

4. There have been a number of proposals on the fiscal side, considering the problem
of ‘extracting rents’ (rather than merely profit taking) in a banking and financial
market which has been largely subsidized by governments’ rescue packages,
monetary and fiscal policies, raises controversy. Acute moral hazard problems
persist. Governments have targeted compensation (such as the controversial 50 per
cent one-off bonus tax on bonus pools of a number of financial institutions in the UK)
and different proposals have been adopted in different countries. Some economists
and politicians have advocated the imposition of a global tax on financial transactions,
akin to the Tobin tax, like the proposed EU financial transaction tax.

5. A fifth group of proposals are bank structural reforms

The aim of these reforms is to change the structure of the banking industry and the
balance sheet structure of commercial banks and other financial institutions.

This is a key thrust of the so-called Vickers Report and its ring-fencing proposals. The
Independent Commission on Banking was established by the Government in June
2010 to consider structural and related non-structural reforms to the UK banking
sector to promote financial stability and competition. The Commission was asked to
report to the Cabinet Committee on Banking Reform by the end of September 2011.
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15
Garicano, Luis and Rosa M. Lastra, ‘Towards a New Architecture for Financial Stability: Seven Principles’
13 (3) Journal of International Economic Law (2010), 599-600.
16
See Huertas, Thomas F. and Rosa M. Lastra, ‘Living Wills’ No: 21 Estabilidad Financiera (November 2011).

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 Its members, Sir John Vickers (Chair), Clare Spottiswoode, Martin Taylor, Bill
Winters and Martin Wolf, published an Interim Report in April 2011 and the final
report in September 2011 (hereinafter, the report). The most controversial and talked
about part of the Vickers Report is the proposed structural separation between
domestic retail services and global wholesale and investment banking operations.
According to the Vickers report, the best policy approach is to require retail ring-
fencing of UK banks. The report argues that this type of structural separation should
make it easier and less costly to resolve banks that get into trouble, should help
insulate retail banking from external financial shocks, thus diminishing problems
arising from global interconnectedness, and should increase the resilience of the UK
retail banking system.

Though the rationale of many of the reforms is sound, a number of legal and policy
issues need to be ironed out (the devil is usually in the detail). First, whenever a fence
or boundary is established, the challenge arises: what should be inside the fence or
boundary, and what should be outside? Boundaries and fences provide all sorts of
incentives for institutions to place themselves in or out, depending on what appears to
be more beneficial for them. The Commission’s view is that domestic retail banking
services should be inside the ring-fence, global wholesale/investment banking should
be outside, and the provision of straightforward banking services to large domestic
non-financial companies can be in or out. Second, would these structural reforms
place UK institutions at a competitive disadvantage? And, finally, given the
limitations that regulation has to promote good conduct, is perhaps too much being
asked of regulation and not enough of improved governance? Finally, the focus of
Vickers is on the UK, not on the European and international efforts that are taking
place in tandem.17

The Commission did a commendable work in putting together an outline of the main
problems and challenges for the UK banking system, trying to come up with sensible
solutions. As in the case of the De Larosière report – which set out the blueprint for
the new supervisory structure in the EU – the members of the Committee had a
mandate that focused on economic issues. It will be up to the legislators to consider
the important legal issues that arise from this blueprint. After all, the law provides the
framework for the licensing, expansion, regulation, supervision and resolution of
banks and other financial institutions and the key attributes of a clear legal framework


For example, how realistic is the possibility that existing UK banking groups could relocate elsewhere in the
European Union (or European Economic Area) and use the single banking passport to establish branches in the
UK (which would not be affected by the ring-fence)? The same considerations apply to non EU banks seeking
to do business in the UK. Will they have an incentive to establish a subsidiary in another EU jurisdiction and
choose to operate in the UK through branches? These are points made in a note written by law firm Slaughter
and May, ‘Resolving the Dilemma of British Banking’ of September 2011.



 are certainty and predictability. It is these last attributes, and the cross-border
dimension, that must be considered in depth in the structural reforms proposed in the
UK.

The narrow banking proposals have been endorsed by John Kay, ‘Narrow Banking.
The Reform of Banking Regulation’,18 while Lawrence J Kotlikoff has made a case
for the mutualisation of the financial industry in his book Jimmy Stewart is Dead:
Ending the World's Ongoing Financial Plague with Limited Purpose Banking
(Chichester: John Wiley & Sons, 2010). The so-called Volcker rule (section 619 of
the Dodd-Frank Act 2010) is also a structural reform. As acknowledged, the Volcker
rule prohibits federally insured ‘banking entities’ from engaging in proprietary trading
(subject to certain exceptions) and restricts their relationships with hedge funds and
private equity funds.

Structural reforms in the EU will be discussed by the ‘Liikanen group’. As announced

by the European Parliament in November 2011, the Commission is setting up a High-
level expert group on structural aspects of the EU banking sector. Commissioner
Barnier appointed Mr Erkki Liikanen (Governor of the Bank of Finland) to chair this
group on 16 January 2012. The group will start working in February 2012.19

The aim of these structural proposals is to circumscribe the scope of institutions that
receive governmental protection, to separate ‘utility banking’ from ‘casino banking’.

6. A note on SIFIs20

Until the financial crisis of 2007-2009 the term too big to fail (TBTF) was mostly
associated with size and with banks. TBTF institutions were typically too-big-to-fail
banks. However, Bear Stearns in 2008 brought a new dimension to this doctrine:
some institutions were too interconnected to fail; AIG confirmed this dimension. Bear
Stearns and Lehman Brothers were investment banks, while AIG was an insurance
company. The TBTF doctrine had moved from commercial banks to securities firms
and insurance companies. Systemic risk is as likely to arise from securities and
derivatives markets as it is from banking markets. This makes systemic risk
prevention a fundamental goal of securities regulation and of financial regulation
generally, and not ‘simply’ of banking regulation.

Today’s SIFIs are an extension of the TBTF doctrine. Some institutions are
considered to be too important to fail and/or too complex to manage, and if they are
too complex to manage, they are obviously to too complex to control/supervise, since
supervision should never have to be a substitute for good management.

18
http://www.johnkay.com/2009/09/15/narrow-banking
19
http://ec.europa.eu/commission_2010-2014/barnier/headlines/news/2012/01/20120116_en.htm
20
See generally Rosa Lastra, ‘Systemic Risk, SIFIs and Financial Stability’, Capital Markets Law Journal, Vol.
6, No. 2, April 2011, pp.197-213.



 And the problems in Iceland in 2008 showed that some institutions were too big to
save.
Systemically important financial institutions or SIFIs – according to the FSB
Recommendations of October 2010 – are financial institutions ‘whose disorderly
failure, because of their size, complexity and systemic interconnectedness, would
cause significant disruption to the wider financial system and economic activity’.
Though as individual institutions SIFIs may be subject to individual micro
supervision (though some SIFIs can be part of the shadow banking system and thus
subject to lesser regulation or no regulation), their systemic significance implies that
they should also be subject to macro prudential supervision. The size or importance of
SIFIs is a source of concern globally and nationally.21


21
I once likened the dangers of SIFIs to the dangers of the baobabs.


There were some terrible seeds on the planet that was the home of the little prince, and these
were the seeds of the baobab. (...) A baobab is something you will never be able to get rid of if
you attend to it too late. It spreads over the entire planet. (...) And if the planet is too small
and the baobabs are too many, they split it into pieces. (...) After explaining how he cleaned
the seeds of the baobabs everyday he added: ‘Sometimes, there is no harm in putting off a
piece of work until another day. But when it is a matter of baobabs, that always means a
catastrophe. I knew a planet that was inhabited by a lazy man. He neglected three little
bushes...’ So, as the little prince described it to me, I have made a drawing of that planet. I do
not much like to take the tone of a moralist. But the danger of the baobabs is so little
understood, and such considerable risks would be run by anyone who might get lost on an
asteroid, that for once I am breaking through my reserve. (...) I say plainly, ‘watch out for the
baobabs’.

‘The Little Prince’ by Antoine du Saint-Exupéry

See Rosa Lastra Inaugural lecture on the Quest for International Financial Regulation:



 There are many problems associated with SIFIs: problems of definition, problems of
effective regulation and supervision and problems of resolution and crisis
management. SIFIs enjoy an implicit government guarantee which generates
pernicious moral hazard incentives. That implicit protection must be priced according
to market mechanisms (I call it ‘market discipline in protection’). Adequate resolution
mechanisms for SIFIs are fundamental. 

A major challenge lying ahead in the treatment of SIFIs is the boundary problem or
perimeter issue. Once a definition of SIFI or global SIFI is established, a clear
boundary is drawn and with it an incentive for financial institutions to position
themselves on one side or another of the boundary, whichever seems more
advantageous. The definition of a SIFI is also dynamic: what is systemic today is not
necessarily what will be systemic in future. And the fact that most systemically
significant financial institutions have a cross border dimension, calls for a cross-
border solution, supra-nationally and/or internationally. 

Final observations

Though financial markets and institutions have grown more international in recent
years, regulation remains constrained by the domain of domestic jurisdictions.22 This
is the ultimate challenge for financial regulation, supervision and resolution. It will
require coherent and consistent international rules as well as improved cooperation
amongst national authorities Whether regulators emphasize the protection of trust in
the system as a whole or of individual depositors, confidence will always be an
essential element in banking and finance.

Confidence and trust are preconditions for a market economy to function efficiently
(the term credit comes from the Latin credere: to trust, to believe), and such trust that
underlies all transactions, that is the foundation of enterprise and development, is
supported by a legal framework. That markets need good rules to function well has
been argued by Ronald Coase and Douglass North, both Nobel Laureates. But long
before Coase and North, the importance of good law for functioning markets had been
recognised. Adam Smith wrote in 1776 :

Commerce and manufacture can seldom flourish long in any state which does not enjoy a
regular administration of justice, in which the people do not feel themselves secure in the
possession of their property, in which the faith of contracts is not supported by the law, and in
which the authority of the state is not supposed to be regularly employed in enforcing the
payment of debts from all those who are able to pay.


http://www.ccls.qmul.ac.uk/docs/podcasts/50504.pdf and http://www.ccls.qmul.ac.uk/docs/podcasts/50499.mp3
22
See generally, Rosa Lastra (ed.), Cross Border Bank Insolvency, Oxford University Press 2011.



 The law, after all, is about setting boundaries for personal and collective behaviour. In
the quest for good regulation we need a combination of general principles (such as
non discrimination or transparency) – which represent a mix of ethics and efficiency
that withstand the passage of time – with more prescriptive technical rules that can be
adjusted to new circumstances with flexibility. In accordance with the principle of
subsididarity some global standards may be not only impractical but undesirable.
There are a number of concepts – credibility, confidence, fairness – that should
permeate through different layers of regulation and influence the behaviour of bankers
and financiers.

The wisdom of principle-based regulation versus reliance upon prescriptive rules

reminds us of the difference between general principles of law anchored in natural
law and positive rules that can change with the passage of time. The debate between
general principles and prescriptive rules has a further connotation that evokes the
difference between primary and secondary law. We need general principles to govern
financial markets. But we also need prescriptive rules. The problem is one of balance
between the two and of quantity and detail with regard to prescriptive rules. In the
immediate years preceding the financial crisis, there was a debate that New York was
losing to London because of its over-prescriptive approach and excessive litigation
(the US society is extremely litigious, a feature that Alexis de Tocqueville identified
in ‘Democracy in America’ and a feature which has not changed). However, in the
aftermath of the crisis, London (i.e., the UK legal financial system) is moving in the
direction of greater prescription.

Changes in the behaviour of the banking industry and bank management cannot be
solely achieved by regulation. Sound risk management and better corporate
governance are also needed. And sometimes the response should not be more
regulation, but better enforcement or use of other tools ranging from taxation and
structural reforms (that circumscribe the scope of institution that receive
governmental protection) to market discipline mechanisms such as greater disclosure.

Good regulation needs to be flexible, proactive, countercyclical, and increasingly

international. It should also rest upon a solid ethical dimension.

We must also remember that markets are part of the solution since it is well
functioning markets that generate growth. President Barak Obama insightfully stated
in his Inaugural Speech of 20 January 2009:

Nor is the question before us whether the market is a force for good or ill. Its power to
generate wealth and expand freedom is unmatched, but the crisis has reminded us that without
a watchful eye the market can spin out of control and that a nation cannot prosper long when it
favours only the prosperous.



 
    
      
       
         
       

   
  







 





 

 




   

 
 



Source: Garicano and Lastra (2010)




Source: http://www.hm-treasury.gov.uk/


