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The purpose of this chapter is to explain the intellectual climate of macroeconomic thinking and policy that helped to foster in the period leading up to the crisis a belief in the inherent stability of finance capitalism, a relaxed regulatory regime for banking and finance and a widening in the scope of capital market activity. The three pillars of this framework were the emergence of a new macroeconomic consensus among new classical and new Keynesian economists, the efficient market theory of finance and the capital structure irrelevance assumption of corporate finance. Each of these pillars had a distinguished list of academic adherents and policy advocates but involved a number of analytical restrictions that limited their scope for clear practical applications.

A rising trend in lawsuits filed against lenders, originators, and home builders erupted as the US housing market started to decline during late 2006 and into 2007. There were a number of other surprising responses to the US mortgage crisis, including the suggestion that local governments use “eminent domain”. Eminent domain usually applies to the government seizure of real property (not loans), such as homes for an urban renewal project or highway construction project. In this case, eminent domain was intended to take underwater, but performing mortgages, in the private label securitization market. The seizure of troubled mortgages would enable the homeowners’ debt to be written down. San Bernardino County in California was one of the first and more visible cases during the crisis where eminent domain was proposed. Numerous criticisms by Wall Street groups and the mortgage industry argued that such a plan would spark lawsuits, higher interest rates, and a tightened market for borrowers.1 The measure was eventually voted down in 2013.

In this chapter, we give an overview of the techniques many banks and investment firms use to satisfy regulatory capital requirements and internally manage their overall market risk. Our focus here is not how front desks hedge their positions, but rather methods aimed at protecting the firm from major losses from market moves or credit events over a given time horizon.

In the wake of the financial crisis of 2007–2008, it has become standard in practice to introduce and implement a serious of valuation adjustments for counterparty credit (CVA), one’s own credit (DVA), funding costs (FVA), regulatory capital (KVA), and initial margin (MVA). This chapter explains the major insights of these valuation adjustments.

Capital adequacy requirement plays a central role in modern regulatory frameworks for commercial banking worldwide. One of the key lessons from the financial crisis of 2007–2008 is the lack of high quality and quantity of capital base during the stressed time period. I explain the regulatory capital requirement on commercial banks that aims to ensure resilient banks and banking systems since 2008. It starts with the concept of capital and then examines the role of the capital for banks to withstand negative business situations. Major insights underpinned in Basel III regarding the capital requirement are highlighted. The chapter itself can be viewed as an introduction on regulatory capital frameworks. These relevenat risk management topics are given extensively in subsequent chapters of this book. .

In this chapter, we discuss the three pillars of operational risk management: capital allocation, transfer of operational risk through insurance, and proactive mitigation of operational risk through product inspection and quality control. Thorough operational risk management will generally involve all three pillars. While the first two pillars are fairly well understood and have been the subject of attention from the Basel Committee and other regulatory bodies, the third pillar is equally important though less familiar to those tasked with operational risk management. Regardless of which pillar an institution elects to rely on for operational risks in general or for a particular operational risk, the procedure to begin managing operational risk is the same.

Much has been written on whether firms in some countries have a lower cost of capital than firms in other countries. This chapter first reviews the cost of capital measurement methodologies employed in prior studies of financially derived competitive advantage (FDCA). The problems with these studies motivate use of an alternative methodology based on widely accepted models of asset pricing in the literature of financial economics.1

The financialization of the economy has brought a number of interrelated problems: financial crises that have led to severe economic downturns with high unemployment, declining economic opportunities, stagnant real wages, and reduced economic growth and thus growing income and wealth inequality. It is time to make a bold change by putting our financial house in order and on a better path. Higher capital requirements for banks, better regulations, supervision and enforcement, and the like are invariably helpful, but at best they will only delay the inevitable, another devastating financial crisis. The prevalence of debt financing is at the heart of the problem. We need more fundamental reform of our financial system that reduces the supremacy of debt, encourages risk-sharing finance, and increases the fraction of reserves in fractional reserve banking.

Capital markets in conventional finance can be broadly divided into three categories; (i) debt markets, (ii) equities or stock markets; and (iii) market for structured securities that are hybrids of either equity or debt securities. Debt markets dominate the conventional capital markets and debt is considered a major source of external funding for the corporate and public sectors. As a result of financial innovations and the application of financial engineering, large numbers of financial products have been developed for resource mobilization. Most of these innovations are variations of plain-vanilla debt or equity security with added optionality or customization. In comparison, Islamic capital markets would come under two major categories: (i) stock markets; and (ii) securitized “asset-linked” securities markets. Due to the prohibition on interest bearing debt financing and mandated risk sharing, stock markets become central to an Islamic economic system.

It would be difficult to find a professional economist who believes that a set of regulatory reforms can be drawn up that would put an end to U.S. financial crises. Crises appear to be endemic to capitalistic systems in which innovation is strongly rewarded and calculated risk-taking is an essential ingredient. Most students of the subject believe, however, that a carefully designed set of reforms focused on correcting numerous socially perverse incentives would reduce the frequency and severity of future crises.

The way an article in the Financial Times had it: “In descending order of understanding on the subject, regulators, the man on the street and politicians all want banks to shrink…markets have started the bank shakedown; regulation is adding to it. Trouble is, bankers are brilliant at defending their jobs.”1 The bankers’ inventiveness creates more than one headache for bank supervisors.

The failure of Lehman Brothers in September 2008 marked the apex of the financial crisis. Twelve months later, by the end of 2009, the worst financial distress appeared to have passed.1 The year saw ongoing discussions on how to strengthen the financial architecture so as to prevent the recurrence of similar events. From this has emerged a broad-based consensus but also a number of unanswered questions. The consensus is worth summarizing, but the unanswered questions deserve particularly careful attention.2

There has been much debate in recent years about whether the Federal Reserve should have taken action against the housing-price bubble as it was forming. One argument in favor of using monetary policy to offset asset-price bubbles is that it may be impossible after the bubble bursts to ease policy hard enough or fast enough to offset a strong contraction. While the fall in housing prices since 2006 has clearly increased unemployment and depressed growth, much less is known about how the costs have been distributed across households of different means. This paper uses data from the Census Bureau's annual American Community Survey (ACS) to examine this question. We first lay out the mechanisms via which a housing-market bust would be expected to affect households, in terms of incomes, employment, assets, and ability to service debt. We then use the ACS data to analyze how the house-price bust has affected households with different characteristics, differentiating between communities in which home prices did and did not boom and bust. Our results suggest that costs of the bubble have tended to fall on households less able to endure periods of financial distress. This lends further support to the argument that monetary policy oriented to social welfare should tackle bubbles ex ante rather than ex post.

It would be difficult to find a professional economist who believes that a set of regulatory reforms can be drawn up that would put an end to U.S. financial crises. Crises appear to be endemic to capitalistic systems in which innovation is strongly rewarded and calculated risk-taking is an essential ingredient. Most believe, however, that a carefully designed set of reforms focused on correcting numerous socially perverse incentives would reduce the frequency and severity of future crises.

Significant progress and enhancements have been made in the reinsurance regulatory landscape during the past decade. This is illustrated by the introduction of the Reinsurance Directive in Europe and in North America with the recent NAIC (National Association of Insurance Commissioners) adoption of a long-controversial proposal for a new reinsurance regulatory framework. Historically, the manner and quality of reinsurance regulation has varied significantly among jurisdictions1—some jurisdictions regulate reinsurers directly,2 others apply a form of indirect regulation through the reinsurance transaction,3 and still others do not regulate reinsurance or reinsurers at all.4 However, the trend today is to strengthen regulatory requirements and to supervise reinsurers directly, not just through their counterparties. This evolution is a result of a number of factors, including the increased activity of the International Association of Insurance Supervisors (IAIS), the advent of Solvency II, the increased complexity and globalization of the (re)insurance industry, as well as the development of more sophisticated risk management techniques.

During the past decade, supervisors around the world have given significant attention to their systems of financial supervision, including capital requirements. Even prior to the recent financial crisis, regulators were rethinking the purpose of regulatory capital requirements and how they should be structured. The financial turmoil has increased regulatory cooperation in this area and increased the importance of international standards.

The insurance industry is constantly reshaped by rapidly changing business and economic conditions. Natural catastrophes have grown in frequency and severity. Changing demographics have put a premium on both risk management and product development. Man-made disasters have escalated in size and unpredictability. Volatile economic conditions have stressed balance sheets and forced new waves of mergers and acquisitions.

The financial world is in a regulatory fever. Following decades of heralded deregulation, the industry seems in need of guidance, to remind the actors of the consequences of cumulating ill-advised incentives and inadequate actions in a sector which increasingly shapes our society. Europe has been developing a new regulatory framework for the insurance and reinsurance industry, aimed at reinforcing the risk management of undertakings and promoting risk-sensitive supervision. Since the first discussions took place in early 2000, Solvency II has grown into one of the most ambitious legislative projects currently in the European Union (EU).

With the globalization of financial services, national interests and inconsistent financial services regulation can contribute to major economic upheavals. Indeed, most would agree that the lack of comprehensive regulation and adequate capital led to the collapse of numerous banking interests in the first decade of the twenty-first century.