Bank failures and regulation: a critical review

Purpose - The purpose of this paper is to define the key components of an effective regulatory regime. Design/methodology/approach - The paper takes the form of a critical analysis. Findings - Regulatory arbitrage has been one of the major factors contributing to the severity of the crisis. Given the ever more complex set of future regulatory constraints, it may keep generating costly negative spillover effects on the whole economy. Moreover, rules‐based regulation, however carefully constructed, will unfortunately never prevent bank failures. Neither should it attempt to do so. An effective overall regulatory regime must be sufficiently comprehensive and well‐balanced. It must not put too much emphasis on lowering the probability of individual bank failure. The key components of an effective regulatory regime must be: Basel‐type rules robust to off‐balance‐sheet arbitrage; little forbearance in monitoring and supervision by regulatory agencies, with a focus on systemic risk control; automatic and quick intervention as well as resolution mechanisms. While all components are necessary, none is sufficient; and without strong international coordination, none will be effective. Practical implications - Enhanced supervision of banks. Social implications - Less costly bank failures. Originality/value - The paper presents a critical review of current financial reforms in the banking sector.