## _spn0907

## Source details

**Canonical URL:** [_spn0907](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/spn/2009/_spn0907.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/spn/2009/_spn0907.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/spn/2009/_spn0907.pdf.json)

---

### Glossary
- IAIS: International Association of Insurance Supervisors
- IOSCO: International Organization of Securities Commissions
- LTCM: Long-Term Capital Management
- OTC: Over the Counter
- SIV: Structured Investment Vehicle
- SPV: Special Purpose Vehicle

### I. Introduction and overview — scope and rationale
- G-20 communiqué (November 15) called for review of the scope of financial regulation, with “a special emphasis on institutions, instruments and markets that are currently unregulated, along with ensuring that all systemically important institutions are appropriately regulated.”
- Prudential regulation traditionally focuses on minimizing failure risk of institutions critical to stability via tools such as minimum capital and liquidity requirements, supervisory inspection, early intervention, deposit insurance, and special insolvency/resolution mechanisms.
- Estimation for the United States: total assets of the “shadow banking system” were roughly US$10 trillion in late 2007, about the same size as those of the banking system.
- Explicit public policy arguments for limiting prudential regulation included:
  - market discipline and self-regulation would curb risk taking;
  - only certain institutions (notably banks with deposit-taking and payment roles) create systemic risk;
  - bank regulation could capture systemic risks from lending outside the core;
  - extending regulation would be costly, reduce innovation, and could increase systemic vulnerabilities.
- Crisis experience challenged those arguments:
  - Market discipline proved ineffective outside banking; unregulated entities assumed credit and liquidity risks funded by short-term borrowings with high leverage.
  - Failures of nonbanks had systemic repercussions (e.g., Lehman Brothers; Bear Stearns hedge funds).
  - Regulation did not capture risks arising from interactions between regulated and unregulated entities (off-balance-sheet vehicles, monoline insurers, weak-originator underwriting).
  - Limited regulation facilitated innovation (e.g., securitization) at high cost when risks were misunderstood.
- Steps to strengthen regulation within the perimeter include clearer consolidation rules, stronger solo and consolidated supervision for securities and insurance firms, and tightened counterparty risk oversight; however, these steps alone are likely insufficient, pointing to a need for perimeter extension.

### II. Crisis lessons relevant to perimeter reconsideration
- Key observations:
  - Significant, often concentrated, credit risks accumulated in unregulated entities, amplifying losses and liquidity pressures in the regulated sector through off-balance-sheet vehicles, leveraged funds, and other intermediaries.
  - Regulators were aware of such risks and took some measures (consolidated supervision, oversight steps toward fund managers, self-regulatory approaches), but underestimated scale, systemic contribution, and regulatory arbitrage drivers.
  - Risk-based capital frameworks addressed some risks inconsistently across business lines and markets; lighter treatment for trading book assets, credit insurance, and off-balance-sheet exposures encouraged arbitrage.
  - Business strategy risks, market-liquidity funding mismatches, and remuneration practices that produced large tail risks were not fully captured by regulation.
  - Rating agencies failed to provide independent evaluations of complex securities.
- Lessons summarized:
  - Market discipline alone is insufficient to constrain systemic risk buildup.
  - Nonbank failures can transmit systemic shocks via confidence effects and direct contagion.
  - Tighter bank regulation can incentivize risk transfer outside the regulated sector.
  - Innovation without adequate oversight increases informational asymmetries and systemic exposure.
- Trade-offs of extension:
  - Extending regulation imposes compliance and opportunity costs, may create arbitrage and moral hazard, and could require clarity on the scope of the safety net.
  - Extensions should be supported by clear objectives, proportionate tools, monitoring for arbitrage, and demonstrable net benefits.

### III. Expanding the scope of regulation of institutions
- Objectives:
  - Ensure all activities that may pose systemic risks are overseen.
  - Broaden systemic significance criteria to include market disruption, loss of confidence, interconnectedness, size, leverage, and funding mismatches.
  - Entities engaged in leveraged financial activities should be regulated regardless of legal form, capturing most SPVs, SIVs, leasing and nonbank mortgage and finance companies; entities legally structured as funds or companies; and some leveraged private equity vehicles.
  - Extension would likely include some hedge funds; historical approach post-LTCM (1998) relied on prime broker counterparty risk management, which did not sufficiently limit fund leverage.
  - Controlling leverage in large hedge funds can help contain market distress.
- Purposes of extending regulation:
  - Provide regulators a comprehensive view of system risk and enforceable reporting to constrain leverage.
  - Improve monitoring of risk transfer and detect development of undetected vehicles (SPVs, SIVs).
  - Give early warning when entities become systemically important so appropriate regulatory requirements can be applied.
- Content of new prudential regulation (tailored to objectives and differences from banks):
  - information and disclosure requirements, with as much public reporting as feasible within a consistent framework;
  - an approach to constrain leverage (calibration may differ from banks given distinct liability structures);
  - liquidity requirements to constrain maturity transformation and liquidity risks from business models like “originate-to-distribute”;
  - governance, risk management (including reputation risk), and remuneration requirements;
  - supervisory arrangements adopting a full risk-based approach, with larger firms subject to regular contact and on-site work focused on intelligence gathering as well as compliance.
- Tiered application:
  - All institutions within an expanded perimeter subject to information and disclosure obligations.
  - Only institutions recognized as systemically important, based on broadly agreed parameters, subject to higher prudential oversight (capital, liquidity, supervisory intensity).
  - Extension of licensing regime to cover all institutions within the expanded perimeter.
  - Firms could be required to report simple measures of total leverage and largest exposures to other leveraged financial institutions; regulators may be empowered to set limits.
  - This regime does not imply extension of the safety net; regulators must clarify this transparently.
- Identifying systemic firms:
  - Dynamic mechanism: when a firm ceases to be systemic it exits the enhanced regime; when it becomes systemic it is brought in.
  - Enhanced regime could include higher capital requirements and early resolution frameworks for systemically important firms.
  - Thresholds should consider more than size (e.g., interconnectedness, substitutability); some businesses may be systemic despite not being large (monoline insurance example).
- Considerations for systemically important nonbanks:
  - Access to liquidity facilities: authorities must decide whether to expand access beyond banks; haircuts and pricing are crucial to minimize moral hazard. If access is denied, legal/regulatory clarity is required to manage expectations.
  - Protection for liability holders: protections akin to deposit insurance do not seem appropriate as the objective is systemic risk reduction; existing investor compensation schemes for conduct-regulated institutions would continue where relevant, but clarity is required.
- Design incentives:
  - Capital charges can favor safer trading environments and use of robust clearing systems.
- Structural requirements:
  - Any business within expanded scope required to separate financial from nonfinancial activities (e.g., manufacturing firm conducting proprietary trading must locate financial activities in a separately capitalized company).
- Governance of regulation:
  - No necessity for a new specialized authority; existing prudential regulators could take on oversight.
  - Development of a new set of regulatory core principles tailored for entities newly in scope, drawing on Basel and IOSCO core principles, to promote consistent implementation including in offshore centers.

### IV. Product and market regulation
- Consider extensions for products that are complex, prone to information asymmetries, and potentially systemically important (examples: collateralized debt instruments and credit default swaps).
- Regulatory nature should include:
  - broader disclosure requirements for marketed securities, accounting for administrative and procedural costs to issuers to avoid excessive compliance burdens;
  - supervisory access to information on structure of complex securities and the nature of underlying risks.
- Direct product regulation is an option but likely to impose transaction and compliance costs and restrict innovation; costs may outweigh benefits in many cases.
- Extend regulatory oversight to the credit-rating process to better address informational asymmetries without excessive intrusiveness.
- Sales and distribution regulation:
  - Fill gaps so conduct-of-business regulation covers agents, brokers, advisers, and originators of all types of financial products, including mortgages.
- OTC markets:
  - Many OTC securities and derivatives markets experienced limited regulation: gaps in issuer disclosure, limited post-trade transparency, and inadequate clearing/settlement (confirmation delays and settlement backlogs).
  - Regulatory changes suggested:
    - extend issuer disclosure requirements to the widest range of securities (with some de minimis exemption for private offerings to small numbers of expert investors);
    - enhance post-trade transparency in OTC markets;
    - reduce counterparty credit risk by improving clearing and settlement processes.
  - Consider extending core IOSCO principles on trading transparency, management of large exposures, default risk, and market disruption to OTC markets.
  - Consider market-maker obligations (continuous two-way quotes within a maximum spread) to improve liquidity, recognizing design and entry challenges.
  - Where products/markets are marketed on the premise of ready liquidity (e.g., auction-rate securities), sponsors should face regulatory obligations mandating liquidity support.

### V. Need for a new regulator objective?
- Consider review of responsibilities for systemic risk reduction.
- Current prudential regulators focus on safety and soundness of individual firms to promote systemwide stability; in some countries, central banks are responsible for financial stability.
- It may be appropriate for regulators to have a specific objective relating to financial stability to ensure they focus on systemwide risks and to reinforce powers to enforce prudential requirements aimed at systemwide stability.
- Where the central bank is not the primary regulator, mechanisms are needed to ensure its assessment of systemic risk is taken into account.

### VI. Conclusion
- The proposals imply a major increase in scope of regulation of institutions, products, and markets and would best proceed as part of broad financial sector reform, including development of a macroprudential framework.
- Proposals aim to extend application of existing regulatory standards to avoid conflicts, with implications for Basel Committee, IAIS, and IOSCO, and interest from private-sector codes (hedge funds, private equity).
- Even proportionate new regulation will increase costs and pose unintended-consequence risks, but the crisis has demonstrated the high cost of the alternative.

### Part II. References
- Brunnermeier, Markus, Andrew Crockett, Charles Goodhart, Avinash Persaud, and Hyun Shin, 2009, “The Fundamental Principles of Financial Regulation,” Geneva Report on the World Economy 11.
- de Larosière, 2009, “Report of the High-level Group on Financial Supervision in the EU,” Brussels, Feb 25, 2009.
- Group of Thirty, 2009, “Financial Reform: A Framework for Financial Stability.”
- Roth, Jean-Pierre, “Highly-leveraged institutions and financial stability—a case for regulation,” speech made on June 29, 2007.

*Source: _spn0907 - References*

### References..............................................................................................................

### References

### Glossary
- IAIS: International Association of Insurance Supervisors
- IOSCO: International Organization of Securities Commissions
- LTCM: Long-Term Capital Management
- OTC: Over the Counter
- SIV: Structured Investment Vehicle
- SPV: Special Purpose Vehicle

### I. Introduction and overview — scope and rationale
- G-20 communiqué (November 15) called for review of the scope of financial regulation, with “a special emphasis on institutions, instruments and markets that are currently unregulated, along with ensuring that all systemically important institutions are appropriately regulated.”
- Prudential regulation traditionally focuses on minimizing failure risk of institutions critical to stability via tools such as minimum capital and liquidity requirements, supervisory inspection, early intervention, deposit insurance, and special insolvency/resolution mechanisms.
- Estimation for the United States: total assets of the “shadow banking system” were roughly US$10 trillion in late 2007, about the same size as those of the banking system.
- Explicit public policy arguments for limiting prudential regulation included:
  - market discipline and self-regulation would curb risk taking;
  - only certain institutions (notably banks with deposit-taking and payment roles) create systemic risk;
  - bank regulation could capture systemic risks from lending outside the core;
  - extending regulation would be costly, reduce innovation, and could increase systemic vulnerabilities.
- Crisis experience challenged those arguments:
  - Market discipline proved ineffective outside banking; unregulated entities assumed credit and liquidity risks funded by short-term borrowings with high leverage.
  - Failures of nonbanks had systemic repercussions (e.g., Lehman Brothers; Bear Stearns hedge funds).
  - Regulation did not capture risks arising from interactions between regulated and unregulated entities (off-balance-sheet vehicles, monoline insurers, weak-originator underwriting).
  - Limited regulation facilitated innovation (e.g., securitization) at high cost when risks were misunderstood.
- Steps to strengthen regulation within the perimeter include clearer consolidation rules, stronger solo and consolidated supervision for securities and insurance firms, and tightened counterparty risk oversight; however, these steps alone are likely insufficient, pointing to a need for perimeter extension.

### II. Crisis lessons relevant to perimeter reconsideration
- Key observations:
  - Significant, often concentrated, credit risks accumulated in unregulated entities, amplifying losses and liquidity pressures in the regulated sector through off-balance-sheet vehicles, leveraged funds, and other intermediaries.
  - Regulators were aware of such risks and took some measures (consolidated supervision, oversight steps toward fund managers, self-regulatory approaches), but underestimated scale, systemic contribution, and regulatory arbitrage drivers.
  - Risk-based capital frameworks addressed some risks inconsistently across business lines and markets; lighter treatment for trading book assets, credit insurance, and off-balance-sheet exposures encouraged arbitrage.
  - Business strategy risks, market-liquidity funding mismatches, and remuneration practices that produced large tail risks were not fully captured by regulation.
  - Rating agencies failed to provide independent evaluations of complex securities.
- Lessons summarized:
  - Market discipline alone is insufficient to constrain systemic risk buildup.
  - Nonbank failures can transmit systemic shocks via confidence effects and direct contagion.
  - Tighter bank regulation can incentivize risk transfer outside the regulated sector.
  - Innovation without adequate oversight increases informational asymmetries and systemic exposure.
- Trade-offs of extension:
  - Extending regulation imposes compliance and opportunity costs, may create arbitrage and moral hazard, and could require clarity on the scope of the safety net.
  - Extensions should be supported by clear objectives, proportionate tools, monitoring for arbitrage, and demonstrable net benefits.

### III. Expanding the scope of regulation of institutions
- Objectives:
  - Ensure all activities that may pose systemic risks are overseen.
  - Broaden systemic significance criteria to include market disruption, loss of confidence, interconnectedness, size, leverage, and funding mismatches.
  - Entities engaged in leveraged financial activities should be regulated regardless of legal form, capturing most SPVs, SIVs, leasing and nonbank mortgage and finance companies; entities legally structured as funds or companies; and some leveraged private equity vehicles.
  - Extension would likely include some hedge funds; historical approach post-LTCM (1998) relied on prime broker counterparty risk management, which did not sufficiently limit fund leverage.
  - Controlling leverage in large hedge funds can help contain market distress.
- Purposes of extending regulation:
  - Provide regulators a comprehensive view of system risk and enforceable reporting to constrain leverage.
  - Improve monitoring of risk transfer and detect development of undetected vehicles (SPVs, SIVs).
  - Give early warning when entities become systemically important so appropriate regulatory requirements can be applied.
- Content of new prudential regulation (tailored to objectives and differences from banks):
  - information and disclosure requirements, with as much public reporting as feasible within a consistent framework;
  - an approach to constrain leverage (calibration may differ from banks given distinct liability structures);
  - liquidity requirements to constrain maturity transformation and liquidity risks from business models like “originate-to-distribute”;
  - governance, risk management (including reputation risk), and remuneration requirements;
  - supervisory arrangements adopting a full risk-based approach, with larger firms subject to regular contact and on-site work focused on intelligence gathering as well as compliance.
- Tiered application:
  - All institutions within an expanded perimeter subject to information and disclosure obligations.
  - Only institutions recognized as systemically important, based on broadly agreed parameters, subject to higher prudential oversight (capital, liquidity, supervisory intensity).
  - Extension of licensing regime to cover all institutions within the expanded perimeter.
  - Firms could be required to report simple measures of total leverage and largest exposures to other leveraged financial institutions; regulators may be empowered to set limits.
  - This regime does not imply extension of the safety net; regulators must clarify this transparently.
- Identifying systemic firms:
  - Dynamic mechanism: when a firm ceases to be systemic it exits the enhanced regime; when it becomes systemic it is brought in.
  - Enhanced regime could include higher capital requirements and early resolution frameworks for systemically important firms.
  - Thresholds should consider more than size (e.g., interconnectedness, substitutability); some businesses may be systemic despite not being large (monoline insurance example).
- Considerations for systemically important nonbanks:
  - Access to liquidity facilities: authorities must decide whether to expand access beyond banks; haircuts and pricing are crucial to minimize moral hazard. If access is denied, legal/regulatory clarity is required to manage expectations.
  - Protection for liability holders: protections akin to deposit insurance do not seem appropriate as the objective is systemic risk reduction; existing investor compensation schemes for conduct-regulated institutions would continue where relevant, but clarity is required.
- Design incentives:
  - Capital charges can favor safer trading environments and use of robust clearing systems.
- Structural requirements:
  - Any business within expanded scope required to separate financial from nonfinancial activities (e.g., manufacturing firm conducting proprietary trading must locate financial activities in a separately capitalized company).
- Governance of regulation:
  - No necessity for a new specialized authority; existing prudential regulators could take on oversight.
  - Development of a new set of regulatory core principles tailored for entities newly in scope, drawing on Basel and IOSCO core principles, to promote consistent implementation including in offshore centers.

### IV. Product and market regulation
- Consider extensions for products that are complex, prone to information asymmetries, and potentially systemically important (examples: collateralized debt instruments and credit default swaps).
- Regulatory nature should include:
  - broader disclosure requirements for marketed securities, accounting for administrative and procedural costs to issuers to avoid excessive compliance burdens;
  - supervisory access to information on structure of complex securities and the nature of underlying risks.
- Direct product regulation is an option but likely to impose transaction and compliance costs and restrict innovation; costs may outweigh benefits in many cases.
- Extend regulatory oversight to the credit-rating process to better address informational asymmetries without excessive intrusiveness.
- Sales and distribution regulation:
  - Fill gaps so conduct-of-business regulation covers agents, brokers, advisers, and originators of all types of financial products, including mortgages.
- OTC markets:
  - Many OTC securities and derivatives markets experienced limited regulation: gaps in issuer disclosure, limited post-trade transparency, and inadequate clearing/settlement (confirmation delays and settlement backlogs).
  - Regulatory changes suggested:
    - extend issuer disclosure requirements to the widest range of securities (with some de minimis exemption for private offerings to small numbers of expert investors);
    - enhance post-trade transparency in OTC markets;
    - reduce counterparty credit risk by improving clearing and settlement processes.
  - Consider extending core IOSCO principles on trading transparency, management of large exposures, default risk, and market disruption to OTC markets.
  - Consider market-maker obligations (continuous two-way quotes within a maximum spread) to improve liquidity, recognizing design and entry challenges.
  - Where products/markets are marketed on the premise of ready liquidity (e.g., auction-rate securities), sponsors should face regulatory obligations mandating liquidity support.

### V. Need for a new regulator objective?
- Consider review of responsibilities for systemic risk reduction.
- Current prudential regulators focus on safety and soundness of individual firms to promote systemwide stability; in some countries, central banks are responsible for financial stability.
- It may be appropriate for regulators to have a specific objective relating to financial stability to ensure they focus on systemwide risks and to reinforce powers to enforce prudential requirements aimed at systemwide stability.
- Where the central bank is not the primary regulator, mechanisms are needed to ensure its assessment of systemic risk is taken into account.

### VI. Conclusion
- The proposals imply a major increase in scope of regulation of institutions, products, and markets and would best proceed as part of broad financial sector reform, including development of a macroprudential framework.
- Proposals aim to extend application of existing regulatory standards to avoid conflicts, with implications for Basel Committee, IAIS, and IOSCO, and interest from private-sector codes (hedge funds, private equity).
- Even proportionate new regulation will increase costs and pose unintended-consequence risks, but the crisis has demonstrated the high cost of the alternative.

*Source: _spn0907 - References*

### Part II.

### Part II.

### References

- Brunnermeier, Markus, Andrew Crockett, Charles Goodhart, Avinash Persaud, and Hyun Shin, 2009, “The Fundamental Principles of Financial Regulation,” Geneva Report on the World Economy 11.
- de Larosière, 2009, “Report of the High-level Group on Financial Supervision in the EU,” Brussels, Feb 25, 2009.
- Group of Thirty, 2009, “Financial Reform: A Framework for Financial Stability.”
- Roth, Jean-Pierre, “Highly-leveraged institutions and financial stability—a case for regulation,” speech made on June 29, 2007.

*Source: _spn0907 - Part II.*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/spn/2009/_spn0907.pdf_