How is the financial system regulated?

Financial regulations are rules that are intended to keep the financial system safe. Some of these rules keep people from getting cheated by their banks — those are consumer protection laws. But there are also a ton of rules which are designed to keep the banking system as a whole from coming crashing down. As you might hope, this last set of rules has gotten a little tougher since the global financial crash back in 2008.

Every country sets its own specific financial regulations, but there is actually one set of standardized international banking rules that lots of countries have signed on to – the Basel Accords, after the town in Switzerland where they were written. The first set of agreements—appropriately called ‘Basel I’—were implemented in the late 1980s. ‘Basel II’ followed in 2004 and Basel III was written during the financial crash and agreed to in 2010.

The central idea of the Basel rules is that everything is safer when banks are holding on to lots of extra money ‘just in case’ . Economists call this money ‘reserves’. But banks’ reserves don’t have to be hard money; a lot of different assets (things like home loans or government bonds) can count as reserves, because the bank can theoretically sell them if they ever need money.

Back in 2008, banks thought they had plenty of reserve assets to meet all their financial obligations. Unfortunately almost every bank was holding a lot of their reserves as home loans. When the economy started to sour and US house prices started to decline, all the banks tried to sell off their bad home loans at the same time, causing the value of the loans—and the value of the banks’ assets—to go into freefall.

Basel III tries to fix this by letting banks only count their safest assets as reserves. Banks are free to hold on to more risky investments, they’re just not allowed to count them as part of their reserves.

The new regulation also deals with two other things that were a problem in 2008: debt and cash flow. Banks and financial institutions are now only allowed to take on so much debt relative to how many total assets they have. This is called a ‘leverage cap’, and it keeps banks from borrowing tons of money that they might not be able to repay.

Banks also have to keep enough cash on hand to cover a about month of operating expenses. This makes sure banks have enough of their assets in a form that’s really easy to spend (like cash) so they can weather short term crises without having to sell off all their longer term assets. Economists call this a ‘liquidity requirement’—liquidity refers to how easy it is to turn an asset into money.

Finally, Basel III does not treat all banks the same—the biggest and most important banks have to follow stricter rules than small banks. Some banks are actually so big, that if they have serious financial troubles, they can cause major problems for the rest of the financial system. These banks are ‘too big to fail’, or in economics talk, ‘systemically important financial institutions’. These big banks have to hold more capital than smaller banks, and usually have to come up with plans in advance for what will happen if they start failing.

The Basle Accords are just the bare minimum that countries agree to follow, so most countries have extra rules on top of these to keep the banking system in check. And as you can probably imagine, people fight about whether these rules go too far, and hurt economic growth, or not far enough to prevent another big crash.