Why banking regulations could not save the financial system during the global financial crisis?

Even today, the world is still suffering from the financial crisis of 2007/2008, which had catastrophic consequences on economic growth, home values, stock prices and jobs. The main reason for this financial crisis in 2007/2008 was the lack of effective and enforced regulations. This article explores the difference between microprudential and macroprudential regulations and why macroprudential regulation were introduced after the crisis to secure the financial system.

Source: FT

There are mainly 2 types of banking regulations: Microprudential and Macroprudential regulations.

Microprudential regulations are regulatory tools that have the primary objective of limiting the probability of the financial distress of individual financial institutions. Before the 2007/2008 financial crisis, policy makers believed that the financial stability and soundness of individual financial institutions would indicate whether or not the whole financial system was healthy and risk-free. This means, that policy makers depended on Microprudential regulations as indicators of financial health, as they believed them to be sufficient.

Unfortunately, this was not the case. The financial institutions in the USA had to be bailed out during the crisis and the government paid a financial bailout worth $700 billion in the form of public aid (taxpayers’ money).

After the crisis, Macroprudential regulation were introduced to secure the financial system. The new regulations include taking the interconnectedness of the financial system and risk of correlation into consideration. Macroprudential policies focus on limiting credit growth during economic expansion phase of economic cycles with the aim of decreasing the pro-cyclicality of the financial system and avoiding systemic risk. Macroprudential regulation also require financial institutions to improve the quality of capital and the amount of capital to be used as a buffer to absorb losses if a crisis occurs.

So, will the new Macroprudential regulations be able to save the financial system during a future financial crisis? To know, we will have to wait and see!

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