policymakers demonstrate

472 Thorsten Beck, Elena Carletti and Itay Goldstein
certain degree of fragility and risk-taking in the financial system. Thus, the
focus should be more on the optimal degree of risk-taking and – what is more
feasible – on minimizing the repercussions of bank failure for the overall financial
system and the real economy. Critically, financial stability is not an objective
in itself, but rather a condition for the sustainability of an efficient and
market-supporting financial system.
The remainder of the chapter is structured as follows. The next section
presents the different regulatory reforms enacted and planned in Europe after
the recent crises. Section 11.3 discusses the market failures in banking as
micro-foundation for bank regulation and maps them to the regulatory reforms
presented in Section 11.2. Section 11.4 focuses on the regulatory perimeter
and efforts by regulated financial intermediaries to use financial innovation to
move risky activities outside this perimeter. Section 11.5 discusses regulatory
challenges specific to Europe, including the overreliance on banks, challenges
related to the banking union and the governance structure more generally. Section
11.6 draws policy conclusions from our analysis and concludes by looking
forward to new research challenges.
Before proceeding, we would like to point to a couple of areas that we are
unable to cover in this survey, given space constraints. One such area is compliance
risk, which has featured prominently in recent years with high penalty
payments either being imposed by regulators or negotiated between regulators
and banks. Another area is that of corporate and regulatory governance. While
we will refer to the new supervisory architecture in Europe in the context of
the discussion on the banking union, we will be unable to go in depth into this.
Similarly, the issue of taxation will not be covered in depth. Another area is
that of the relationship between competition and stability, where ambiguous
theoretical predictions have given rise to a large number of empirical studies.
Finally, we will focus primarily on the banking system, where regulation has
traditionally been centred, but we will discuss the need for and challenges in
expanding the regulatory perimeter.
11.2 Recent Financial Reforms in Europe
The main financial reforms introduced after the 2007 Global Financial Crisis
are contained in the new Basel III regulatory standards. The new accord introduces
a stricter definition of capital, a higher quality and quantity of capital,
two dynamic capital buffers, a minimum leverage ratio, and two minimum liquidity
ratios. The Basel III accord is implemented in Europe through the Capital
Requirement Directive IV (CRD IV), whose objective is to create a level
playing field across countries. The package contains a directive and a regulation.
Key aspects of the Basel III accord such as the new definition of capital
and the liquidity requirements are included in the regulation and will thus