Various systemic risk regulations methods are applied to financial systems according to prevailing risk conditions and the regulations’ convolution as well as the individual uniqueness. Worldwide coordination of bank supervision can only be achieved through informal means (Felton & Reinhart, 2008, p. 37). Three mainly applied regulations are: 1. Capital Requirements: First the regulators measure each individual firm’s contribution to the systemic risk.
Once the firm’s systemic risk contribution level is outlines, the regulators then compel the firm to stick to some requirements and/or costs dependent on the firm’s contribution level - capital requirements is one such way of compelling firm’s. That is, the regulator should impose a capital requirement that depends explicitly on systemic risk contributions. This would be the appropriate incentives to firms to limit their increment on amassed risk as custody of capital reserves is can be expensive and it gives the firm the desired safety cushion in financial systemic crises.
Concentrating on systemic risk can as well be a clear development over any already applied or existing regulations, but for this to be so, it them has to be efficiently and effectively enforced. To ensure this happens, there has to be a defined limit on the capacity to reduce evident leverage by the movement of assets to off-balance sheet but with remedial measures, or by depending entirely on book ideals. Besides this measure, quantification of systemic risk has to be taken as being a-cyclical or counter-cyclical to counter probable fire sales that would otherwise be encouraged by breach during financial crises.
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2. Regulation by ‘Taxing’ the externality: Taxing activities that inflict negative externalities on any given financial system is the same as taxing any activity that may lead to a financial systemic risk. According to Acharya et al. (2008); The tax has two benefits: (i) it discourages behavior that leads to systemic risk, and (ii) the generated levies would go towards a general “systemic crisis fund” to be used in the future by the regulators to inject capital into the system (at their discretion).
Of course, in equilibrium, some institutions will find it optimal to still engage in these behaviors and therefore pay the higher taxes, while others will lessen their use (p. 8). Though small firms may have minimal or not tax imposed on them due to low effect on the systemic risk incase of financial hardships, the large and complex financial firms would be the greatest to get the tax burden imposed on them as their failure would effect great deterioration in the financial system. 3. Regulation Using a Market-Based System:
In this regulation method the regulators would let the financial and broader market evaluate and give an estimate of the financial systemic risk. All firms under regulation would then have to purchase insurance against future losses in a universal crisis only. This regulation scheme would help firms keep externalities internal and enhance every firm’s willingness to either purchase the insurance or build a capital base that would cushion it against future losses that may be incurred in the event of a financial failure.
In the event of a firm opting to purchase insurance against future losses then the purchase contract would have to be drafted in detail and the insurance company would have to pay the regulating firm a percentage of any rate that falls below the target. I case of increasing insurance market that the private sector may not be able to fully cover the market; the government can come in and insure the financial firms’ capital against future losses. To ensure that the firms continue to be monitored, then they have to keep buying the insurance.
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