policymakers demonstrate

Financial Regulation in Europe: Foundations and Challenges 503
increasing the complexity of the financial regulation might provide the industry
players with stronger incentives to make their institutions more complex.
Second, complex financial regulation opens the door for the manipulation of
rules by financial institutions and investors. For example, when capital requirements
introduced risk weights, banks could have more discretion in how they
measure and report risk, and this might have led to greater risk-taking. Similarly,
forcing banks to hold additional capital or impose higher risk-weights for
specific activities that expose the bank to higher risks and/or are not considered
central to financial service provision is a pricing-based tool, whereas outright
prohibition of certain activities (e.g., trading on own account) is a simpler
tool to achieve the same. While a pricing-based tool might be better to balance
social benefits and costs, complete prohibition might be better in case of uncertainty
about (the distribution of) costs and benefits. Hence, in our view, it is
important to complement ever-increasing complex regulation with some simple
rules. For example, going back to a simple leverage ratio in the new Basel
accord in addition to risk-weighted capital requirements is a step in the right
direction.
The second policy lesson has to do with the new emphasis on macroprudential
policies, as opposed to the traditional micro-prudential policies. As the
recent crisis made us realize, making sure that individual institutions are sound
may not be enough, as they all may be taking action to secure themselves, but
these can make the system as a whole less secure. New policy measures such as
bank stress tests and capital requirements that depend on the aggregate state of
the economy are steps in the right direction in trying to take the systemic risk
aspect into account. But, a considerable amount of work is still needed for measuring
systemic risk, and assessing the effectiveness of macroprudential policy
measures more precisely.
The third policy lesson has to do with the required focus on resolution. The
chaos that came with the failure of leading financial institutions was arguably
an important factor in how deep the global financial crisis was. It is thus critical
to have frameworks in place to resolve financial intermediaries in a way that
minimizes disruptions for the rest of the financial system and the real economy,
while allocating losses according to creditor ranking. An incentive-compatible
resolution framework has therefore not only important effects ex-post, that is, in
the case of failure, but also important ex-ante incentive effects for risk-decision
takers. This implies that a lot of attention and preparation is needed now before
the actual failure of big and complex institutions. Imposing living wills and
requiring bail-in strategies in case of failures are indeed important steps that
will make institutions think more about the event of the failure and internalize
better the risks that they are imposing on the system. But again much more
work on the effectiveness of resolution mechanisms and the legal aspects of
what can and cannot work is needed.