The Regulation of Systemic Risk

Jorge A Chan-Lau

Before the global financial crisis of 2008 it was seldom considered that the main mandate of financial regulation was to prevent systemic risk and mitigate its effects. Traditionally, financial regulation has aimed at two objectives: to ensure the solvency of financial institutions on a stand-alone basis; and to reassure their clients and consumers that the institutions followed appropriate market practices, including complying with high standards of transparency and disclosure.

Praiseworthy and relevant as these two objectives are, which have increasingly come under the purview of microprudential policy, they are insufficient for protecting the financial system from a generalised breakdown with severe consequences for the real economy. The failure of microprudential policy to prevent financial crises was due to its focus on financial institutions in a vacuum, isolated from the rest of the financial system and the real economy. Therefore, by design, the traditional regulatory framework could not capture the linkages across institutions, the role institutions play in the dynamics of the credit cycle, and the feedback between the credit cycle and the business cycle.

Moreover