policymakers demonstrate

488 Thorsten Beck, Elena Carletti and Itay Goldstein
institutions. They only transpire from a systematic approach, focusing on the
aggregate risk, distribution of risk and linkages between different market participants.
It is important to realize that these linkages and thus sources of contagion
might change over time, reflecting the dynamic nature of the financial
landscape. If there is one common trend, it is the increasing complexity of the
banking world, a theme we will return to below.
11.3.2 Mapping between Basic Failures and the Reforms Enacted in Europe
In this section, we review the recent regulatory reforms described in Section
11.2 in light of the basic failures in the financial system described above. Our
main question is what problem(s) each specific reform tries to address and what
potential challenges still remain for financial stability. Given the complexity of
the issues, we restrict ourselves to the main regulatory reforms: capital and liquidity
requirements, banking union and resolution regime. Although we make
use of the existing empirical evidence, our discussion is mostly of a theoretical
nature.
Capital Requirements
Capital performs various functions and helps to alleviate the three basic failures
in the financial system that we have discussed before. It absorbs unanticipated
losses, thus reducing the risk of insolvency for a financial institution and contagion
through the financial system. Moreover, by protecting uninsured investors,
capital helps maintain confidence in the financial system. Finally, capital is an
important tool to provide incentives to bank managers and shareholders not to
expose the bank to excessive risks.
The academic literature has mostly focused on capital as a way to reduce the
problem of limited liability and excessive risk taking due to high leverage and
the (implicit or explicit) support of financial institutions through widespread
deposit insurance and bailouts. The general idea is that because banks have
access to low cost funds guaranteed by the government, they have an incentive
to take significant risks. If the risks pay off, they receive the upside, whereas
if they do not, the losses are borne by the government. Capital regulation that
ensures that shareholders will lose significantly if losses are incurred is needed
to offset the incentive for banks to take risks. One way of capturing this is
to model the effects of capital on banks’ monitoring incentives (Holmström
and Tirole, 1998). Using this framework, Dell’Ariccia and Marquez (2006)
and Allen et al. (2011) have shown that capital regulation does improve banks’
incentives to monitor, although its effectiveness depends on the presence and
design of deposit insurance, credit market competition etc. Overall though, this
literature supports a positive role of capital and thus of capital regulation in
ameliorating banks’ incentives to monitor borrowers, thus reducing the credit