The Quest for Financial Stability: Determinants of Regulatory Approach in Banking Supervision: Does Counter-Cyclical Regulation Play a Role?

Abstract

Effective banking supervision is important for ensuring financial sector stability. A country’s choice of banking sector regulatory approach has an impact on banks’ lending decisions and the overall availability of credit in the financial system (Greenwald and Stiglitz 2003: 5–8). Market-based regulation was prevalent in the decades leading up to the 2008 global financial crisis. This approach is based on the assumption that if sufficient information is available on the marketplace, market discipline will force financial actors to behave responsibly, and will thus promote financial stability (Barth et al. 2006; Wymeersch 2009; de Haan et al. 2012). However, reliance on market regulation allowed excessive risk-taking in the financial sector and destabilized the global financial system. Recently, scholars and policy-makers have considered the potential of implementing counter-cyclical regulatory measures to make the financial sector more resilient (Griffith-Jones et al. 2009; Independent Commission on Banking 2011). Proponents of counter-cyclical regulation argue that bank supervisors need to take pro-active measures when they observe vulnerabilities in the banking system, especially to cool off credit booms (Grabel 2007; Goodhart and Persaud 2008).