Capital regulation in the new world: The political economy of regime change

One of the striking things about moving from the UK to the US is that there is a quite different emphasis on explanations of the great financial crisis. I have found that here it is widely regarded as a liquidity crisis, whereas in London most people would say that it was, at root, a solvency crisis. Exaggerating somewhat, here higher capital requirements are advocated in order to reduce the incidence of self- fulfilling runs. In London, higher capital is advocated to reduce the probability of fundamental insolvency.

Yale School of Management, Program on Financial Stability

Paul Tucker, Harvard Kennedy School and Harvard Business School

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One of the striking things about moving from the UK to the US is that there is a quite different emphasis on explanations of the great financial crisis. I have found that here it is widely regarded as a liquidity crisis, whereas in London most people would say that it was, at root, a solvency crisis. Exaggerating somewhat, here higher capital requirements are advocated in order to reduce the incidence of self- fulfilling runs. In London, higher capital is advocated to reduce the probability of fundamental insolvency. My own view is, and throughout my involvement in the international reform programme was, that the crisis was driven by both liquidity and solvency problems. Of course, the liquidity run on banks and shadow banks put the economy and asset values on a lower path, and so eroded the margin of solvency in many intermediaries. But the margin of solvency started off wafer thin at many intermediaries, so not much had to go wrong in the economy for some firms to be underwater.

I am going to open my remarks with an account of regulatory requirements before the crisis, which I will suggest puts into perspective why the international authorities didn’t set a higher equity requirement in Basel 3. Then I will step back and argue that , individually and in combination, stress testing and the introduction of macro-prudential regimes bring about a revolution in capital policy: substantively and in terms of political economy. I shall conclude with some advocacy of why it makes sense to add a debt- requirement to the minimum equity-requirement, in terms of ensuring a firm’s resolvability and in enhancing market discipline. As befits my slot, some of the brush strokes will be broad.