At the beginning of their article, they point to the fundamental trilemma of financial supervision. They sait that only two out of these three incompatible objectives can be achieved:

1. Stable financial system.
2. Integrated financial market.
3. Independent national financial supervision.

The authors also define contagion as shocks which propagate from one financial institution to the other by two channels (p. 266):

• Exposure channel: domino effects resulting from real exposures in the interbank markets and/or in payment systems.
• Information channel: contagious withdrawals (bank run) when depositors are imperfectly informed about the type of shocks hitting banks and about their physical exposure to each other (asymmetric information)

He mostly focuses on the role of the Central Bank in the financial system, and in particular about how the Bank of England evolved as bank for the government, a holder of reserves and a lender-of-last-ressort for commercial banks.

Most importantly, he focuses on the informal role of the Bank of England (p.54) and an intermediary between banks and government:

For its part, the goverment relied on the Bank to introduce, monitor and maintain (if not quite enforce) its commands; while the banks and other intermediaries knew that they had to get the Bank on their side inf ay speciial pleadings that they wished to make would be taken seriously by the government. This role provided considerable informal leadership of the City for the Bank.

He also explains that due to that informal role, there were rarely any major banking crises between 1945 and 1973 (p.54):

Banking was an extremely safe, and boring, occupation between 1945 and 1973. There was little credit risk, though there was considerable interest-rate-risk.

The Bank of England rarely had to be active as lender of last-ressort during these years and restricted itself as an arbiter of concerted private sector responses to a crisis.

The change in 1970 and the expansion of credit that came along with it created so-called fringe-banks whose rationale it was to avoid direct controls by the supervisors. These banks often had little capital, highly leveraged, but due to the boom in the property market highly profitable as well.

With the Oil Shock in 1971, high interest rates to combat inflation, the boom ended in a crisis and the collapse of a fringe-bank called “London and County Securities Group” led to a collapse of further fringe-banks. The Bank of England tried to co-ordinate injections of liquidity with the private sector to save some of the salvageable fringe-banks.

What this episode revealed was that there was little, or no, prudential control, or supervision, of the banking, or wider financial, system, and that, in the new competitive, and thereby riskier milieu, such oversight was felt to be necessary, and wouldneed an associated regulatory dimensenion. (p. 57)

The fringe-bank crisis was a British problem, the failure of the Herstatt Bank was an international problem. The Herstatt Bank had speculated heavily in foreign-exchange transactions and in the Eurodollar-Market. The German authorities closed the bank after financial markets closed in Germany, but before the foreign-exchange-markets closed in New York, causing large disruptions there.

The Basel Committee on Banking Regulation and Supervisory Practices was created after the Herstatt Failure and chaired by delegates from the Bank of England until 1988. The Herstatt Failure led to the Basel Concordat which divided responsibility for supervising international banks between host and home authorities. The shutdown of the Banco Ambrosio by the Italian authorities in 1981 even though the Bank was registered in Luxemburg increased the need for co-operation between bank supervisors.

Goodhard explains the shift from liquidity adequacy to capital adequacy (p. 59) in banking supervision:

A bank [...] whose capital [...] had been eroded to a low level would be much more prepared to gamble for resurrection than a better capitalized bank. Also, the greater the capital, the greater the loss that could be absorbed. On those simple insights a huge regulatory edifice has been erected.

In 1979, after a decade of high inflation and low interest rates, the US Federal Reserve drastically raised interest rates to combat inflation. Meanwhile major commercial banks recycled the deposits from petro-dollars from the high oil-prices to loans to developing countries. The high interest rates caused the 1982-Latin-American-crisis and brought some American commercial banks to the brink of insolvency.

French, German and Japanese bank however were less exposed to the credit risk associated with loans to developing countries and gained a competitive edge against the Americans banks. Between 1982 and 1988, Americans and British tried to agree on a common capital adequacy standard which would take into account the different models of banking business in the various countries. The agreement, called the 1988 Basel Accord, introduced capital requirements which were weighted by the relative riskiness of the asset of the bank.

In his conclusion, Goodhard explains the basic mechanism of crisis-driven financial regulation (p. 62)

Something goes wrong in the financial system, and some people lose money. Almost by definition the existing system of supervision and regulation is to be held at fault. The Press takes up the cry, ‘Heads must roll’. Since the politicians do not want it to be their own heads that become parted from their bodies, they feel the need to be seen to be taking actions to make sure that that particular disaster never happens again.

So financial innovation, and new potential disasters, breed new kinds of regulation and supervision. The key innovation in this respect is, in these last 40 years, been the growing global reach of financial intermediation, via globalization and IT. This causes a real proplem because regulation is about laws, and laws are national in character, whereas financial intermediation is now international.

• Financial supervision
• Bank regulation and money laundering
• Corporate Governance
• Insolvency Regimes
• Financial stability and the EMU
• Cross-Border Payment Systems
• Securities clearing and settlement

Some of these chapters will be discussed in later posts.