A central objective of regulatory reform is to minimise the potential for the costs of bank failure to be passed to tax payers. The core objectives are two-fold: to lower the probability of bank failures, and to lower the cost of those failures that do occur. A central theme is that reform needs to be strategic rather than incremental, with more emphasis given to reducing the costs of bank failures. Problems that threaten financial stability are in part endogenous to the regulatory regime: the “endogeneity problem”. This arises as banks seek to circumvent regulation through financial innovation and by changing the way business is conducted. The case is made for a substantial rise in bank equity capital. The overall assessment is that much higher capital requirements are likely to imply little net social cost but significant systemic benefits.

The regulatory regime needs to encompass credible, predictable, and timely resolution arrangements. The objective is to allow banks to “fail” without disturbing business and customer relationships, and to ensure that the costs of failure fall on private stakeholders (equity and bond holders and other unsecured creditors) rather than tax-payers....