THE CRITICAL FAILINGS in BANKING REGULATION

Throughout the history of financial crises, prudential regulators and central banks have been considerably involved in developing a wide spectrum of regulatory tools to ensure the smooth functioning of the banking sector and maintain financial stability. Deposit insurance, Lender of Last Resort (LLR), prudential regulation and supervision have been extensively discussed in academic and literature as the three major components of government financial safety net. In the midst of these regulatory tools, the regulation of bank capital stands out as one of the most critical in the view of fostering banking stability and preventing financial crises. Regrettably, bank capital regulation (Basel II) has turned out to be a "massive fiasco", probably the one of the most crucial main failings in banking regulation that intensified the severity of the recent global financial turmoil. Firstly, this chapter will discuss the history and rational behind bank capital as regulatory tools, and secondly examine the extent to which Basel II contributed to both the occurrence and the severity of financial crisis 07/08. Finally, we will examine the nexus between financial innovation and systemic risk, and critically discuss how central banks and financial regulators have lost sight of systemic risk control in the light of weaknesses of the incumbent macro-prudential regulatory framework.

HISTORICAL PERSPECTIVE OF BANK CAPITAL REGULATION

The Banking system performs special functions including: asset transformation, liquidity insurance, development of payment systems and transmission of monetary policy impulses, investment monitoring, and risk diversification. The nature systemic banking risk and the pivotal role of banks in promoting economic development have been culminant considerations that underpin the rationality of banking regulation, Goodhart et al (2001, p.10) and Llewellyn (1999). One important lesson policy makers have learned from historical episodes of financial crises is the intrinsic fragility of the banking sector. Asset-liability maturity mismatches, banks runs and stock market crashes or any turbulent financial shocks at macro-level can deplete banks' capital, resulting in systemic banking failures and serious disturbances in the financial system. The interconnectedness between banks with "derivatives networks" and financial linkages intensify the gravity of banking sector problems and eventually result in a widespread of counterparty and systemic risk, leading to severe economic contractions and disruptions as we witnessed during the recent financial turmoil that followed the subprime crisis, Heffernan (2005). The main rationale behind introducing minimum capital adequacy requirement was to ensure that Banks hold sufficient capital to buffer against adverse financial shocks and unexpected losses, thus foster banks solvency and financial stability. Santos (2000, p.1) explained the importance of bank capital "from the role it plays in banks' soundness and risk-taking incentives, and from its role in the corporate governance of banks".A He argued that bank capital help not only reduce excessive risk taking and moral problems of created by deposit insurance, and but also consolidate the stability of the banking system by reinforcing the "stand alone strength" of banks in the midst of unexpected brutal financial storms, thus containing the eruption of systemic banking failures and minimizing the cost of government bailouts. Strong capital buffers are meant to absorb bank losses and minimize the occurrence of bank failures. The higher are the risks exposures of a Bank, the higher will be its capital charges; bank capital standards act a disciplinary mechanism that monitor Banks risk taking incentives. According to Allen and Gale (2007.p.193), bank capital plays a key risk sharing function by acting as a buffer that offsets depositors' losses and allows "orderly liquidation of the bank's assets" in the worse scenario of a bank failure. They further argued that incomplete markets justifies regulators' involvement in setting bank capital to ensure optimal risk sharing and social welfare though appropriate capital rules that effectively mitigate the negative systemic externalities of bank failures. In 1988, G10 Nations signed Basel Accord for international bank capital standards. On December 1992, Basel I capital regulated were implemented to ensure that Banks hold sufficient capital to buffer against their credit risk exposures. Fast pace developments in financial innovations, market-based finance, securities and derivatives trading led policy makers to amend Basel I in 1994 and 1999 to provide more accurate capital provisioning covering wider aspects of financial risks including market risk, interest rate risk and operation risk. In June 2004, as a response to mounting criticisms against Basel I that followed the Asian financial crisis [1997-98], the Basel Committee for Banking Supervision (BCBS) published a new complex framework with three pillars titled Basel II. First of all, Basel I was criticized for inadequately coverage of all bank risks exposures. Secondly, risk calibrations and weightings were too simple and not properly done, thus did not accurately reflect actual underlying risks, Weber (2009). Thirdly, most importantly Basel I framework neglected issues regulatory arbitrage, Jackson et al. (1999). Atkinson et al (2008b, p.70) argued that Basel I allow Banks to easily manipulate their capital requirements using a disintermediation strategy by "shifting between on-balance sheet assets with different weights, and by securitizing assets and shifting them off balance sheet". As a result, financial institutions accumulated excess capital, higher than minimum regulatory requirements, which regrettably did not constrain their risk appetite, Blundell-Wignall et al (2008). Basel II was scheduled to be fully operational by the end of 2006. However, the complexity of risk-sensitive capital requirements calibration under Basel II was so complex that it required longer transition periods than previously planned. Many financial institutions had not yet fully implemented Basel II till 2007 when the subprime crisis erupted in the US. Though Basel II cannot be fully blamed for triggering the subprime crisis, the entire financial crisis has thrown significant light on deficiencies of Basel II regime. Consequently, appropriate corrective measures have been implemented in the so called "Basel II enhanced framework- 2009" and many other financial reforms are underway to strengthen banking regulation at an international level.

UNDERSTANDING THE DEFICIENCIES OF BASEL II SYSTEM

PILLAR 1: Risk Measurements

Basel II is based on three pillars. The first pillar defines minimum capital level banks should hold as reserve to buffer against unforeseen losses. The calibration of risk adjusted capital adequacy requirements is based on complex risk weights applied separately to different asset classes and then summed up to determine total Risk weighted asset ( risk coverage included: operational risk (OR), credit and market risk (MR)). The basic principle under Pillar I is to assign capital charges based on the size risk exposures. Simply put: the higher the risk exposures are, the higher is the level of capital buffers imposed. Calibration of capital requirements: {RWA= {12.5(OR+MR) + 1.06SUM [w(i)A(i)]} (where: w(i) is the risk weight for asset I A(i)) see: Atkinson et al (2008b, p.72 }. Basel II provided Banks with three options with regard to their risk assessments based on which capital charges are defined. Small financial institutions with no capacity to model their risk and quantify their risk exposures internally could follow either the simplified approach with the fixed risk weights terms defined in Table 1, or a second approach based on external rating provided by Credit Rating Agencies (CRAs). The third option is the "internal ratings-based (IRB) approach" under which big sophisticated banks are allowed to use their internal risk management model to assess the probability of default (PD) and losses given risk exposures at default (LGDs), Blundell-Wignall et al (2008). The IRB system required not only high caliber internal expertise to gauge risk-sensitive weights with complex aggregation and quantitative risk modeling methods; but also high level of banking supervision to ensure full disclosure, transparency and accuracy of risk inputs in these financial risk models. In all cases, it is critical to properly calibrate risk for capital regulation to be effective.

Source: Adrian Blundell-Wignall and Paul Atkinson (2010)

BASEL II COMPOUNDED BANKS' APPETITE FOR MORTGAGES

As we discussed earlier on in the previous chapter, macroeconomic conditions (abundant liquidity and low interest rates between) led financial institutions to seek after higher return. Atkinson, Blundell-Wignall, and Lee (2008a) argued that Basel II stimulated financial institutions' appetite for mortgage financing, hence helped fuel the housing bubble. Under Basel I, 50 % capital weight was required for on-balance sheet mortgages and Zero for secruritzed mortgages shifted off balance sheet through SIV, while newly published Basel II (2004) required 35%, and possibly as lower as 15% or 20% for sophisticated banks, depending their ability to use the complex internal ratings-based (IRB). However, under Basel II capital charges will apply for mortgages whether treat on and off balance sheet. The Basel Committee allowed banks to anticipate new bank capital rules (Basel II) before they become fully operational in January (2008) as planned in many countries. It is therefore rational that lower capital weights inevitably made mortgages more attractive for large banking groups such as Citi and Northtern Rock that opted for (IRB), allowing them to aggressively invest in residential mortgage backed securities (RMBS) to generate higher return on capital for low-capital-weighted mortgages, (see: Figure 1, Basel II advance estimates compared to Basel I Minimum Capital for Commercial Banks in the US). Fannie Mae and Freddy Mac (GSEs), main players in the US mortgage market, grew their mortgage portfolios from $160Bn to $1.5 trillion between 1990 and 2003. The Fed did not respond to this systemic threat, but rather stimulated the housing bubble with excessive quantitative monetary stimulus post the 2001 recession. These low interest rate policies triggered a demand bubble for mortgages, resulting in GSEs mortgages portfolio exploding to approximately $3.2 trillion in 2007, Carosio (2010). Blundell-Wignall and Paul Atkinson (2008a) have empirically modeled the impact of Basel II introduction in 2004 on RMBSs acceleration (see Summary of result in Figure 2). In 2004, many other financial institutions which continued to operate under Basel I immediately responded to this regulatory arbitrage opportunity by rapidly accelerating mortgage lending through extensive off-balance sheet securitization vehicles (SIV), while awaiting Basel II to become fully operational.

Figure 1 Figure 2: Model-based Contributions to the RMBS Explosion

RISK CONCENTRATION AND REGULATORY ARBITRAGE

The Basel system defines Risk adjusted Capital requirement based on a mathematical model many assumptions, most notably the "portfolio invariance" assumption; that is risk adjusted capital charges "should depend only on the risk of that loan, not on the portfolio to which it is added" Atkinson et al (2008b, p.72). Mathematically speaking, capital charges for credit risk exposures of mortgage loan rises linearly with respect to holdings in that assets type, but remain independent to the exposure size "that is, appropriate diversification is simply assumed"! Blundell-Wignall et al.(2010, p.4). Such assumption facilitates the application of mathematical models underpinning Bank capital rules with the convenience of simple additivity. However, not only "portfolio invariance" rules out the importance of specific risk diversification and its impact on the overall portfolio risk, but it also most importantly fails to consider the concentration risk in the portfolio. This created an arbitrage opportunity created that enable banks to expand their investment in profitable mortgage lending by significantly leveraging their capital without considering the danger of excessive risk concentration mortgage assets.

THE NORTHERN ROCK EXAMPLE

Northern rock, a key player in the UK mortgage market, was one of the first banks to anticipate Basel II and choose IRB approach. The Bank aggressively concentrated and grew its mortgage assets by excessively rolling short-term debt. Northern rock's rapid expansion of mortgage products in anticipation of Basel II was fully fueled by massive liquidity funding on wholesale markets which regrettably did not properly match with its liabilities. As a result, the explosion of the subprime meltdown (with falling house prices, collapse of CDOs markets and huge default mortgages products, liquidity frozen on financial markets), Northern rock to suffered a bank run; the first bank run recorded in Britain since 1866. Northern rock achieve considerable average annual assets growth rate estimated to 20% and concentrated more than 75 % of its assets in mortgage related assets to lower their capital charges. The regulatory arbitrage opportunity led the bank to forgo an "equity building culture" for credit expansion culture based on "debt building" in order to uplift shareholders return on capital and share price, Atkinson, Lee et al (2008, p.9). In June 2007, as the subprime earthquake began to erupt, Northern Rock recorded GBP 2.2bn equity capital and GBP 113bn total assets, making the bank one of the most highly leveraged in the midst of the liquidity turmoil. Their risk weight asset under Basel II was GBP 19bn, equivalent to 16.7 % total assets; while Under Basel I their capital charges amounted to GBP 34bn (a ratio of 30 % to total assets), Atkinson, Lee et al (2008, p.9). Bank of England intervened with £23 billion liquidity injection; approximately "15times the amount of regulatory capital required by Basel II [£1.52 billion]", Rochet (2008, p.7).

MORAL HAZARD AND THE ROLE OF CREDIT RATING AGENCIES

In the IRB approach risk inputs are subjective and this exacerbates moral hazard problems in the banking system in the absence of a tight and robust supervisory framework. Off balance sheet and over the counter risk exposures (like CDSs) were not fully observable by financial regulators. Also, the unavailability of sufficient historical data (about new structured financial products) made it a difficult task for quantitative risk managers to model and forecast risk exposures; increasing the tendency of banks to become less transparent in risk disclosure and manipulate inputs in risk modeling to reduce their bank capital requirements, Blundell-Wignall and Atkinson(2008b). According to Bair (2007), Chair of the Federal Deposit Insurance Corporation (FDIC), the key risk inputs that drive the advanced approaches are subjective unreliable and unproven." In the context of the subprime crisis, financial regulators failed to exercise higher level of due diligence vis-à-vis the reliability and accuracy of IRB system of banks. As a result of risk was mispriced and capital charges were inconsistently lower with regard to actual risk. The role of Credit Rating Agencies in the financial turmoil 07/08 has been extensively discussed. External rating by CRAs is a fundamental part of risk assessments approaches under pillar I (Basel II). CRAs, legally authorized risk experts, were trusted enough not only with the potential to advise banks on risk rating and analytics, but also with the capability to provide credible, consistent and accurate inputs to risk ratings, based on which regulatory bank capital are charged. However, this overreliance in CRAs turned to be scandalous, particularly regarding the misprice of risk associated to senior tranches of CDOs that were rated triple AAA, making them seem riskless and very attractive to investors. As matter of fact CRAs boosted the demand CDOs which eventually helped boost the housing bubble. Also, the misprice of risk, led to insufficient capital buffers that has significant increased the magnitude of banks vulnerability due to excessive risk concentration in subprime related exposures.

PRO-CYCLICALITY EFFECTS

Heid (2003), Gordy and Howells (2004), Pederzoli et al (2009) provide substantial evidence of pro-cyclical effects of risk-sensitive bank capital requirement. While asset prices tend to increase the upper phase of the business cycle, in contrast, the riskiness of assets tend to fall, encouraging bank to take on extra risk and aggressively compete to increase their profit in so called "good times". Brunnermeier, Goodhart et al (2009, Page xii) argued that competitive forces activates an automatic disciplinary mechanism, causing banks to respond to the dynamics of markets development during economic booms by: "(i) expanding their balance sheets to take advantage of the fixed costs of banking franchises and regulation (ii) trying to lower the cost of funding by using short-term funding from the money markets and (iii) increasing leverage". According to Nickell et al. (2000), Bangia et al. (2002), macroeconomic and market conditions are keys drivers of asset values, stock market volatility and credits risk factors across the entire business cycle. It therefore becomes rational that risks vary in line or "pro-cyclically" with the business cycle, increasing the tendency to lax risk judgments in good times and overestimate them is bad times. Dowd (2009, p.161) and Repullo and Suarez (2009) explained how risk inputs in IRB and external rating (CRAs) tends to be less rigorous in times of economic booms as compared to recession times, leading to degrade risk weights in expansion phases of the business cycle. This ultimately resulted in lower capital charges in good times, as we have witnessed during the recent housing bubble, encouraging credit expansion through excessive leveraging of capital when a downturn is most probable. Dowd (2009) argued that the procyclicality of Basel II risk sensitive capital requirement contributed to the severity of crisis. Figure 3 is a perfect graphical illustration of risks fluctuation over the business cycle in the United States. The chart is graphical representation of the trends in aggregate assets as a ratio of risk-weighted assets over the US business cycle (represented by trends in GDP). We could easily observe that risk weighted assets followed a downward trend during the high tech bubble also referred to as the dot com bubble (1998-2000). Oppositely, following the bursting of the dotcom bubble which triggered the 2001 recession, risk weighted asset took an upward sloping trend. The same procyclical effects were also remarkable in the last phase housing bubble with the introduction of Basel II in 2004.

Figure 3: US GDP and Total Assets/Risk-weighted Assets

Blundell-Wignall and Atkinson (2008b) argued the IRB approach and external rating of CRAs (Under pillar I) exacerbated this procyclicality impact. He explained that neither banks nor CRAs predicted with complete accuracy future asset prices and stock market volatility. They all based their risk rating estimations of probability of default and loss given default based on actual business cycle conditions. Financial innovations (CDOs, CDS) facilitated regulatory arbitrage by making possible for banks to reduce their capital charges by either shifting risk off balance through SIV (motor of securitization process) or transferring credit risks to other financial counterparts by trading CDSs. Faulty risk assessments permitted banks to become highly leveraged, up to 40:1, Blundell-Wignall et al (2008a). Basel II over-relied on both banks internal risk rating models and credit rating agencies' risk assessments which unfortunately turned out to be too procyclical.

FAILINGS IN BANKING SUPERVISION: PILLAR 2 AND 3

Pillar 2 emphases on the banking supervision process in which prudential supervisors stress test banks' soundness and provide them with essential prudential guidance to ensure that they hold sufficient capital buffers for risks that might have been overlooked under Pillar 1. An effective banking supervision review process requires a forward looking approach with dynamic provisioning of capital charges to effectively in counteract all risks misjudgments under Pillar I. The extraordinary complexity large financial institutions and instruments and fast pace nature of financial markets movement makes a challenging task for supervisors to keep themselves updated with dynamic markets practices, structures and complexity, and to forecast with accuracy futures markets volatility and assets prices, Blundell-Wignall (2008a, p75) . The subprime crisis was mainly a sequel of massive supervisory failures. It is interesting to know that Bair (2007), Chair of the FDIC, expressed dubious concerns on regulators ability to mitigate the shortcoming of risk-sensitive bank capital rules. He argued that the unreliability of capital adequacy standards makes it even more rational to question the ability of "ill-equipped" financial supervisors in overcoming the defects of capital standards requirements (in Pillar I). Scientists including astronauts, physicians, engineers and mathematicians are now heading quantitative risk modeling teams within large financial institutions. These risk modelers often called "quant" determine internal risk tolerance using extremely complex mathematical financial models such as Value at Risk models (VaR), (the most widely used risk model, often discredited for being alarmingly sophisticated, inaccurate and grounded in misleading assumptions), Dowd(2009). Dowd (2009, p.148) argued that sophisticated VaR Models used by banks are unreliable due to high level "complexity (and so greater scope for error), less transparency (making errors harder to detect), and greater dependence on assumptions (any of which could be wrong)". Banking supervisor were far behind latest trends of financial innovation, particularly in risk management, and as a result could not match the level of expertise of investment banks quantitative risk modelers. Regulators did not have skills to accurately assess and control risk-taking and dynamically gauge capital charges. Not only supervisors overrated internal risk management models, but their extreme lasses-faire attitude vis-à-vis banks potential to adequately manage their risk exposures internally created exorbitant moral hazard problems that eventually ruined institutional risk management systems and corporate governance. For example, in the United Kingdom, the Financial Services Authority (FSA), renown as one of the best highly sophisticated financial supervisors with qualified staffs, authorized Northern Rock adherence to Basel II IRB approach. Though FSA fully understood that this decision would significantly reduce and weaken Northern Rock's capital, but it couldn't exercise supervisory due diligence and prevent the bank from compounding risk taking, expanding lending through leveraging of capital, excessively concentrating its assets in mortgages products to benefit lower capital charges. Pillar 3 places emphasis on market discipline and disclosure and enforce sanctions to ensure sound and transparent risk management practices within banks. Having discussed the shortcomings of the supervisory review process, the unreliability and subjectivity of risk inputs in internal risk management models (under IRB approach), and the procycilaty of risks, it is rational to be skeptical about the accuracy risk reporting. How can supervisors ensure market discipline if they can properly assess risk themselves? Financial markets volatility and bubbles, and the complexity of new structured financial securities make the mark-to-market reporting complicated and inaccurate. In addition, risk reporting for OTC traded derivatives and off-balance exposures are extremely difficult and very demanding for both to supervisors and insiders; giving enough room to these last one to manipulate their institutional risk management system to achieve higher return, hence worsening moral hazard problems. KPMG's Audit Committee research survey (2008) indicated out of 1 080 audit committee members (including 150 in the UK), only 38% were satisfied with internal risk reporting, Kirkpatrick (2009, p.11).

FINANCIAL INNOVATION AND SYSTEMIC RISK

Though deficiencies of the Basel system enable financial institutions to lower their capital requirement and expand mortgage lending to uplift returns, the debate about casual distortions in banking regulation cannot be ended without further elaborating on the key role played by financial innovations both in the housing bubble and the spread of systemic risk. As financial institutions aggressively sought after higher return in the midst of the global liquidity bubble, the crisis recorded an uncontainable explosion of highly complex financial innovations on a global scale. Credit Default Swaps (CDSs) and Collateralized Debt Obligations (CDOs) are incontestably the most popular structures financial products that have played a critical role in the financial crisis, see Figure 4&5. In simple terms, CDOs are bonds underlying pools of asset back securities such as mortgages; and CDSs is a credit risk transfer contractual agreement between a buyer and a seller, where by the seller agrees to compensate the buyer in the event of default in exchange of periodic fee till the CDS contract reaches maturity. The originate distribute model enabled banks off load risks from their balances through structured investment vehicles (SIVs) and facilitated credit risks transfer to a wide spectrum of investors into wider markets. Figure 4 Figure 5: Growth in CDS Before the crisis, many were those who firmly believed that the securitization will strengthen financial stability through effective dispersion of credit risk, making macroeconomic and adverse financial shocks easily absorbable and spread across a diversified pool of investors, Shin (2009). Before the subprime crisis, the IMF (2006,p.51) also believed that "the dispersion of credit risk by banks to a broader and more diverse group of investors, rather than warehousing such risk on their balance sheets, has helped make the banking and overall financial system more resilient." When the subprime crisis erupted, everyone including Financial regulators got to realize that risk transfer through securitization can contribute to financial fragility and increase systemic risk in the absent of adequate supervision. Demyanyk and Hemert (2007) and Keys et al. (2007) provide solid empirical evidence that securitization eroded sound principles of underwriting standards and resulted in very poor credit quality. According to Aloko and Tuson (2010, p.6), "the Mortgage Meltdown marked the end of this age of ignorance and lifted the veil on the ugly truth of securitization". It is very regrettable that prudential regulators neglected the simple fact that credit risks transfer will enhance financial stability in the short run but at the detriment of rising systemic risk in the long run. The more risk is transferred through complex and highly leveraged financial instruments (such as CDSs or CDOs), the stronger becomes interdependencies and financial linkages between counterparts within the financial system, hence the higher level of systemic risk! Regulators overlook the danger of CDOs and CDSs systemic risk exposures and "how this exposure could be managed if the worst comes to the worst" Chorafas (2009, p. xii).

"SLUMBERING REGULATORS" AND SYSTEMIC RISK

Fannie Mae and Freddy Mac (GSEs) grew their mortgage portfolios from $160Bn to $1.5 trillion between 1990 and 2003, and then to approximately $3.2 trillion in 2007, Carosio (2010). The senior tranches of CDOs were rated AAA by CRAs, making them appear very attractive and as safe as US government bonds, while in reality they were very risky junk bonds. The markets for CDOs grew rapidly to approximately $1.2 trillion by the end of 2007 according to IMF statistics. CDSs' markets was over the counter, out of control, unlimited and significantly exploded to feed investors' natural instincts to mitigate their credit risk exposures to collateralized debt obligations (CDOs). Investment banks heavily traded CDSs to hedge against their excessive risk concentration in mortgage related assets; over $60 trillion CDSs were outstanding in the wake of the subprime meltdown (Dowd 2009, p46). CDSs eventually became a major source of revenues for many financial institutions and large insurance companies. For example Lehman Brothers had approximately $ 400Bn outstanding CDSs obligations to honor, Brettell Karen(2008). A greater systemic trouble would have evolve if the US federal government did not provide $170Bn immediate assistance to AIG, which was also on the edge of bankruptcy with over a $1.6 trillion in CDSs obligations to counterparts including US large investment banks and many other large financial institutions across the globe. Lehman's bankruptcy in Sep 2008, the greatest of financial story, triggered a systemic spread of credit defaults and financial panic on international financial markets. The fear of counterparties risk severely contracted liquid on interbank markets as banks felt insecure lending to each other, see figure 6&7. The systemic fallout of Lehman Brothers' collapse "has exacerbated the liquidity crisis and the international market situation, which had been unsettled for more than a year", see: Bank of France Commission Bancaire (2008). Rapid propagation of contagion risk led to uncontainable systemic breakdown that undermined global financial stability and exacerbated financial markets distress. The lack of due diligence and inability of financial regulators to impose markets discipline and anticipate the systemic implications uncontrolled financial innovations (complex securitizations, unlimited networks of toxic CDS) compounded systemic risk and resulted in a highly leveraged and fragile banking system. According to Chorafas (2009, p. xiii) financial regulators including FSA, SEC "watched this happening in the false belief that markets correct their own excesses". They all got it wrong, and macroprudential regulation inevitably failed.

Figure6: Three month and interbank rate Figure7: Financial market liquidity indexes

Source: Bloomberg: (e) Lehman Brothers Bankruptcy Source: Bank of England, 2009

POOR MACRO-PRUDENTIAL SURVEILLANCE

Based on the experiences of past financial crises, Davis E P (1999) examined financial data and macroeconomic indicators needed for macro-prudential surveillance. The table below show a cross county study that indicates different factors which have led to historical episodes of financial crises across the globe, see Table 2. It is interesting to notice that most factors which caused financial crises in the past as the same which triggered the recent global financial turmoil. There is enough reason to believe that regulators either have chosen to be blind and neglect all early signal of the development systemic risk in financial system, or they were incapable to impose market discipline on banks. The debt bubble originating from both macroeconomic imbalances and extensive securitization, the excessive risk concentration in mortgage products, the housing bubbles, decline in lending standards, faulty risk reporting and supervisory systems, uncontrolled financial innovations, unlimited trade of toxic OTC derivatives (CDSs) were clear symptoms that a financial crisis was under way. These alarming alerts should have been timely addressed to prevent or contain the severity of the recent financial turbulence. Do regulators really learn from their past mistakes, many were the warning signals to the subprime meltdown, debt accumulation financial innovation and risk concentration, unfortunately as the Larosière report confirm there was no regulatory responses till these embryonic systemic risk signals fully developed and engulfed the entire the financial system. The High-level group on financial supervision in EU (Report 2009, p40) affirmed to have identified macro-prudential risks "there was no shortage of comments about worrying developments in both macroeconomic imbalances and the lowering price of risk, for example; [However] there was no mechanism to ensure that this assessment of risk was translated into action". Table 2: Macro-prudential surveillance indicators Davis E P (1999)

THE UK EXAMPLE

In the United Kingdom, macro-prudential regulation failed due defects in the tripartite regulatory system introduced by Gordon brown in 1997 under which the banking supervision functions were separated from Bank of England and delegated to an independent and well structured financial regulator (FSA). In the context of regulatory failures in the UK, it is no longer a secret that the FSA overemphasized on micro-prudential regulation (the supervision of individual financial institutions) and unfortunately paid less attention to systemic risk developments in the financial system (macro-prudential supervision). The FSA not only failed enforce market discipline on banks excessive risk taking and leverage (Northern rock case) but also had no capabilities to gauge systemic risk and stress test the stability of the UK financial system as a whole. The tripartite structure resulted in imperfect information flows between the Bank of England and the FSA, leaving the central bank "with no powers over the banks and a bank regulator with no remit to monitor the bigger picture" Osborne (2009, p.15). A clear lesson to retain from the financial is that systemic risk has significantly grown in today's' globalized financial system and as such a perfect coordination between micro and macro prudential regulation is imperative to ensure financial stability.

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