Equity

Ten Precepts for 21st Century Regulators

The regulatory reforms that followed the financial crisis of 2007-09 created a financial system that is far more resilient than the one in place 15 years ago. Yet, the events of March 2023 make clear that the progress thus far is simply not enough. To ensure resilience, we need to do more.

To steer the process of further reform, we propose a set of 10 precepts that those who make the rules should keep in mind as they refine the prudential framework. These practical guidelines lead us to conclusions that mirror those in a recent post: regulation should be more rule-based (less reliant on supervisory insight or discretion); simpler and more transparent; stricter and more rigorous; and more efficient in its use of resources. Concretely, this approach means increasing capital and liquidity requirements; shifting to mark-to-market accounting; and improving the transparency, flexibility and severity of capital and liquidity stress tests.

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A Primer on Private Sector Balance Sheets

Double-entry bookkeeping is an extremely powerful concept. Dating at least from the 13th century (or possibly much earlier), it is the idea that any increase or decrease on one side of an entity’s balance sheet has an equal and opposite impact on the other side of the balance sheet. Put differently, whenever an asset increases, either another asset must decrease, or the sum of liabilities plus net worth must increase by the same amount.

In this post, we provide a primer on the nature and usefulness of private sector balance sheets: those of households, nonfinancial firms, and financial intermediaries. As we will see, a balance sheet provides extremely important and useful information. First, it gives us a measure of net worth that determines whether an entity is solvent and quantifies how far it is from bankruptcy. This tells us whether an indebted firm or household is likely to default on its obligations. Second, the structure of assets and liabilities helps us to assess an entity’s ability to meet a lender’s immediate demand for the return of funds. For example, how resilient is a bank to deposit withdrawals?

After discussing how balance sheets work, we show how to apply the lessons to the November 2007 balance sheet of Lehman Brothers—nearly a year before its collapse on September 15, 2008….

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