There is still little unanimity on how to deal with some of the fundamental problems that were revealed by the recent financial crisis and, more important, how to prevent the next crisis. Despite the efforts of policy-makers around the world in crafting reforms, there are some major unanswered questions about how authorities should apply the lessons of the recent crisis.

The biggest area of progress has been the efforts to raise capital requirements for global banks. Although the details of that initiative still have to be sorted out over the next year or so, there does seem to be at least some consensus that these requirements must rise. Other issues, such as banker compensation, have also received attention.

What haven’t been addressed are the overarching problems of systemic risk, and the moral hazard that’s inherent in a financial system that will not allow certain firms to fail. Small, insignificant firms will be allowed to fail, but there are a host of institutions around the world that are now considered too big, too interconnected or just too important to public confidence to be allowed to fail. And policy-makers have yet to determine what should be done about this dilemma.

As the governor of the Bank of England, Mervyn King, said in a recent speech in Edinburgh: “It is hard to see how the existence of institutions that are ‘too important to fail’ is consistent with their being in the private sector. Encouraging banks to take risks that result in large dividend and remuneration payouts when things go well, and losses for taxpayers when they don’t, distorts the allocation of resources and management of risk.”

King suggested that the government interventions deemed necessary to save the financial system a year ago have created “possibly the biggest moral hazard in history.” And, he argued, this situation can’t be allowed to persist. The question is what to do about it.

Some have suggested that supervisors limit the size of banks. Others propose that the big banks be broken up, and that the riskier trading and capital markets activities be separated from the basic banking functions of taking deposits and making loans. Still, others have proposed a tax on financial transactions to limit “unproductive” trading activity and possibly to fund some sort of insurance scheme for these institutions.

The governments of the G-20 had considered the possibility of a tax on financial activities at their latest meeting, which was held in Pittsburgh in late September. And a report from Toronto-Dominion Bank’s economics department indicates, without hope, that the International Mone-tary Fund will study the idea and report back on it by June 2010: “It is far from clear anything beyond just an IMF report will emerge on this front, but it is worth watching.”

An obvious tool that can be used to deal with the systemic risks is regulation — the idea being that regulators can do much more to detect and deter the buildup of such risk. Policy-makers in both Europe and the U.S. have called for the creation of systemic risk regulators to do just that. And the topic was high on the agenda of the B.C. Securities Commission’s latest annual conference, which was held in Vancouver in mid-October.

At that conference, Malcolm Knight, now vice chairman of Deutsche Bank Group and previously CEO with the Bank for International Settlements, argued that there is a role for regulators in dealing with systemic risk, saying the financial crisis demonstrated that it is very difficult for the private sector to assess systemic risk — and even if it can perceive it, it’s also very difficult for it to do anything about it: “It’s not so easy for the private sector to adjust to system-wide risk, because if you’re a good CEO and you see it coming, and you build a war chest, and nobody else does, you may be out before you get a chance to prove you were right.”

Knight suggests there should be government agencies charged with watching out for systemic risk, such as those being proposed in the U.S. and Europe, but he also conceded this is much easier said than done.

For one, it can be just as tough for regulators to detect these sorts of risks as it is for private players, and it would also be politically difficult to do anything about it if these risks do reach worrying levels. Moreover, the practical realities of performing this task are likely to prove very tricky, particularly if there are consequences for specific firms as a result of efforts to limit systemic risk (such as higher capital requirements or other restrictions on firms that are deemed to be systemically important).

@page_break@Despite these difficulties, Knight said, there is a need for greater regulation of systemic risk: “It’s a huge challenge. It needs to be done, but it isn’t going to be easy.”

At that same conference, Greg Tanzer, secretary general of the Madrid-based International Organization of Securities Commissions, noted that IOSCO is examining the role of markets in transmitting systemic risk, and is contemplating the role of securities regulators in mitigating it.

However, Tanzer stressed, the role of regulation should not be to eliminate risk: “It’s easy to think of systemic risk as something that needs to be removed, but the real issue is appropriately managing risk.” Indeed, he pointed out, there’s not much to finance without risk.

Tanzer also suggests regulators need to think about the role market transparency and business conduct rules can play in ensuring systemic risks are recognized and mitigated.

Knight had suggested that improving transparency could help create a fundamentally more stable financial system, pointing out that other asset bubbles have been allowed to form and, later, pop without causing the damage that this most recent crisis has wrought — in part, because they occurred in markets with much more transparency.

Notably, the stock market crash of 1987 didn’t have anywhere near the impact on the overall financial system as the recent crisis. An equities market crash like 1987’s isn’t necessarily a systemic problem, Knight said, because the products are standardized, there’s better disclosure and regulation works better in that arena. “We need to build,” he added, “some of the disclosure, consistency, standardization rules that have worked so well in the equities market into structured credit products.”

Knight also argued that there must be much greater co-ordination and harmonization among national regulators. With a more harmonized international system, he suggested, regulators may be able to do more to prevent the sort of contagion that spreads problems from market to market. IE