How crisis-resistant are today's financial markets? A Global Regulatory Regime for Financial Markets? That's Wishful Thinking

Questions & Answers

The Lehman Brothers bankruptcy three years ago precipitated a global financial crisis whose repercussions can be felt to this day. Prof. Dr. Michael Schröder, head of the research department of International Finance and Financial Management at ZEW, talks about the successes and failures of financial regulation in the wake of the Lehman Brothers collapse.

Prof. Dr. Michael Schröder is the head of the research department of International Finance and Financial Management at the Centre for European Economic Research (ZEW). His research focuses in particular on the empirical analysis of capital markets, expectation formation in financial markets, socially responsible investments, and the asset management activities of foundations. In 2009 he received his venia legendi in business administration from the University of Stuttgart. In addition to his work at ZEW, Schröder is professor of asset management at the Frankfurt School of Finance & Management.

Have financial markets become more crisis-resistant since the collapse of Lehman Brothers?

The regulatory requirements instituted under Basel III are a step in the right direction. The most important change was to raise the minimum level of core capital banks must hold and to narrow the definition of what can be considered core capital. This should help protect banks from unforeseen lending losses. It remains to be seen, however, how well the new regulations will perform in a crisis. In particular, will the proposed capital buffers – the capital conservation buffer and the countercyclical buffer – be able to absorb the considerable procyclical effects of bank regulation? Another contested issue is the level of minimum equity capital. Research in multiple countries indicates that the costs associated with requiring additional equity capital are low. In light of the immense cost of the most recent financial crisis, this speaks for raising minimum equity capital levels significantly, perhaps to somewhere between 16 and 20 per cent.

What remains to be accomplished in the regulation of financial markets?

Numerous areas in financial market regulation need to be expanded and improved. One area yet to receive sufficient regulation is hedge funds, i.e. investment funds that speculate on share prices or sell securities they do not own. Another area is rating agencies. The central problem of biased incentives when rating agencies are paid by the institutions for which they provide ratings remains to be addressed. Still another concern is that few countries have regulations governing the restructuring and liquidation of systemic banks in crisis situations, and the regulations in place are limited and disparate. Restructuring and, if needed, liquidation are means to mitigate the “too big to fail” problem of large banks. It would also make sense for countries to adopt more or less unified regulations, at least within Europe, and ideally globally. Unfortunately, however, the likelihood of this happening – say, at the G-20 summit of government leaders this coming November – is, in my view, very low.

Does stricter financial market regulation threaten to shift speculation to unregulated sectors?

We have little reliable information in this regard. But I think we can assume that Basel III’s tighter capital regulations will motivate some people to operate in unregulated sectors. To prevent this, more must be done to regulate so-called shadow banks. I’m thinking particularly of hedge funds, which traditionally have low equity capital levels and speculate mostly using borrowed capital.

How can the shadow banking sector be better regulated?

One place to start is commercial banks. When lending to, say, hedge funds, these banks should be subject to far stricter capital requirements. Banks should be permitted to provide hedge fund capital only if they disclose information about the fund’s activities, so that regulatory agencies can properly assess the risks. In addition, countries must continue to push for global regulation requiring the registration of hedge funds, thus enabling direct oversight.