Potential regulation of firms that pose a systemic risk to economies must first tackle the issue of how to define an institution that is "too big to fail", according to regulation professionals speaking at the International Centre for Financial Regulation summit in London yesterday.
A representative of the US Securities and Exchange Commission (SEC) suggested that the answer was to increase supervision of firms that pose a systemic risk to an economy, to avoid situations where governments have to bail them out with taxpayers' money, as happened with American International Group in the US and Royal Bank of Scotland in the UK.
"Financial entities that are perceived as being 'too big to fail' have an incentive to take too much risk in the hope of high returns with the belief their governments will always step in if things go badly. They should be regulated to take away this incentive," said Ethiopis Tafara, director of the Office of International Affairs at the SEC.
But creating new rules to achieve this is not a straightforward task: regulators will have to first define the parameters that separate them from normal companies.
"What is a 'too big to fail' institution? And once that is defined, regulators would have to draw up a list of firms that qualify as having systemic risk and a list of those that don't," said Carlo Comporti, secretary-general of the Committee of European Securities Regulators.
One of the potential issues is that it could result in many firms hovering just below the parameters that define them as a systemic risk, and therefore avoiding more regulation, warned Tafara.
Other issues around regulatory reform raised at the conference included the importance of supervisors across the globe making any new significant changes in unison to avoid firms trying to taking advantage of regulatory arbitrage.
Also discussed were possible new countercyclical rules that would build up banks' capital buffers in bull markets and allow this to reduce during recessions.
Recent new reports suggesting reforms to financial regulation include those released in February by the Financial Services Authority's (FSA) chairman Adair Turner and the European Union's High Level Group on Financial Supervision's chair Jacques de Larosière, which covered many of the issues raised at the conference.
See also: SEC official hopes G-20 will establish "broad parameters" for regulation
Bernanke calls for regulatory overhaul of financial system
FSA plans new capital formula for banks
De Larosiere calls for ECB to lead European macro supervision
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