Improving Banking Supervisory Mechanisms
In the OIC Member Countries
7
pave the way for the build-up of system-level vulnerabilities and simultaneous failures.
Expectations of possible bailouts provide further incentives to take these actions.6 Similarly,
financial institution should keep up with their competitors for performance and market
reputation motives. When other institutions increase their leverage and expand their balance
sheets, it is optimal to expand one’s balance sheet as well, which leads to inefficient credit
booms and systemic risk.7
Ex-post externalities, on the other hand, refer to the contagious effects of the failure of a
financial institution. As discussed above, a stressed institution with insufficiency of capital
engages in deleveraging through a fire sale of assets, which puts a downward pressure on asset
prices: a phenomenon known as asset downturn spirals. Ex-ante commonality in risk
exposures leads to a deterioration of asset prices of other institutions, which exacerbates the
effect of the failure.
It is now well-understood that micro-prudential regulation should be complemented with
macro-prudential policies to achieve an effective regulation and supervision scheme.
Regulatory authorities should closely monitor development in the financial system and act in a
flexible manner in the application of individual regulations. For example, imposing higher
capital or liquidity ratios during times of stress, alongside a policy that loosens these ratios to
avoid fire-sales and mitigate the systemic impacts of the financial stress, may be optimal.
An important lesson learned from the 2008 financial crisis is that extensive credit growth may
reach to unsustainable level, which is usually seen concurrently with increased leverage levels
and expanded balance sheets. Individual institutions do not internalize the systemic impacts of
their actions8, as they abide to capital requirements. This leads to the possibility of aligned
deleveraging in the case of financial stress, driving down asset prices and collateral values and
drying up liquidity in the system.9 Macro-prudential policy might be effective during credit
booms by increasing the required capital ratios to sustain resilience in the system or by
limiting the expansion of credit through a direct reduction in the amount of lending.
In this regard, Basel III, representing the new framework of financial regulation, introduces
elements that reflect concerns about systemic risk along with strengthened regulations on
capital requirements10. The ingredients of Basel III related to the systemic risk concerns are
the countercyclical capital buffer and capital surcharge for systemically important financial
institutions, as will be discussed extensively in the next section.
6See Acharya and Yorulmazer (2007), Farhi and Tirole (2011).
7See Aikman, Haldane and Tanaka (2012).
8Known as the coordination failures. See Morris and Shin (1998).
9See Lorenzoni (2008) and Bianchi (2011)
10See Basel documents, Bank of England (2011) discusses potential application of macro-prudential policy in detail. Also see
Morris and Shin (2008) on the financial regulation aiming at mitigating systemic risk.