Banking: Why Does Regulation Alone Not Suffice? Why Must Governments Intervene?

The position this paper takes is that if all institutional investors are bound by regulations that force them to sell risky assets during downturns, these assets will ultimately be absorbed by unregulated long-term investors. Additional examination shows that, in the current environment, sovereign wealth funds and governments are the possible buyers of these assets. As public intervention entails moral hazard, it follows that for the stability of the financial system throughout the business cycle regulations must be improved. Our proposal
is to include buffers—by which we mean an amount of regulatory capital that will vary over the business cycle and could eventually disappear provided it is recovered over the medium term—above minimum capital requirements in the prudential regulations.