The financial crisis that engulfed the world in 2007 and 2008 has led to a wave of re-regulation and discussion of further regulation that has culminated in the proposals from the Basel Committee as well as those in the Vickers Committee report on Banking Regulation and Financial Crises. This issue of the Review contains a number of papers on Banking Regulation, covering many aspects of the debate, and we can put that debate in perspective through these papers and also by discussing our work on the relationship between bank size and risk taking, which is reported in Barrell et al. (2011). We addressed the causes of the crisis in the October 2008 Review, and began to look at the costs and benefits of bank regulation in Barrell et al. (2009). In that paper we argued that we needed to know the causes of crises and whether the regulators could do anything to affect them before we discussed new regulations. It is now generally agreed that increasing core capital reduces the probability of a crisis occurring, and most changes in regulation that are being discussed see this as the core of their toolkit. The work by the Institute macro team in Barrell et al. (2009) and in Barrell, Davis, Karim and Liadze (2010) was the first to demonstrate that there was a statistically important role for capital in defending against the probability of a crisis occurring, and our findings were widely used in the policy community in the debate over reform.

At the global level, GDP growth accelerated to 1.2 per cent in the final quarter of 2010 according to NIESR estimates — largely driven by a sharp rise in domestic demand in China, which more than offset a slowdown in world trade growth that originated in the US. The economic recovery in the advanced economies remains lacklustre. The sharp rise in the oil price in recent months has exacerbated the effects on output of the protracted downturn in global investment and a tighter fiscal policy stance, at least in Europe. High commodity prices will push inflation in the OECD close to 3 per cent both this year and next. At the global level we expect GDP growth to moderate from an estimated 5.2 per cent in 2010 to just below 4½ per cent per annum in 2011–12, with around half of this slowdown attributable to the effects of the increase in oil prices between October 2010 and April 2011. The key assumptions underlying this forecast are discussed in Appendix A, with our forecasts for key macro variables in 40 major economies detailed in Appendix B.

The headline figure for US GDP growth in the final quarter of 2010 was perhaps slightly higher than expected given the slowdown in Europe and Japan, at an annualised rate of 3.1 per cent. But a closer look at the components of GDP reveals an underlying weakness in the US economy. Domestic demand stagnated in the final quarter of 2010, and the strong rise in GDP is entirely attributable to a 12.6 per cent (annualised) contraction in import volumes. The slowdowns in Europe and Japan should be seen as at least partly attributable to this loss of demand from the US, which remains the world's largest importer of goods and services, accounting for about 12½ per cent of world trade (see Appendix figure B3). Available information for the first quarter of 2011 suggests that consumer spending growth moderated to about 1½ per cent at an annualised rate, and we expect GDP growth in the US to average about 2½ per cent per annum this year and next.

The performance of the UK economy has deteriorated markedly since autumn 2010. The volatility of output due to the adverse weather experienced last winter masks the underlying weakness in the UK economy. The Office for National Statistics (ONS) preliminary estimate of GDP suggests the underlying level of output has been flat since the third quarter of 2010. We expect the economy to grow from the second quarter of this year onwards, as we can see from figure 1, but we continue to expect this growth to be relatively weak. We expect GDP growth of 1.4 per cent per annum this year, rising to 2 per cent in 2012.

The housing market plays a fundamental role in the economy, and its functioning affects both consumer welfare and economic stability, as the recent crisis has made clear. Research by Barrell et al. (2010) shows that house prices are a key determinant of financial crisis probabilities in OECD economies, and contribute significantly towards systemic banking risk. This must lead the regulator to assess carefully the role of the housing market in this relationship, and if necessary impose regulatory restrictions on the market so as to ensure it functions in a way that reflects the best interests of the economy. In this note we look at the evolution of real house prices in the UK, noting that they have a strong cyclical pattern. We then look at the factors that might affect the evolution of real house prices, and we estimate a dynamic equation describing those prices. After considering a wide set of factors, we demonstrate that there is little role for the supply of housing relative to the number of households. This may be because the ratio of these two variables has been relatively constant over the past thirty years. We show that real borrowing costs, real incomes and the loan-to-income ratio are significant factors determining the long-run path of real house prices, and that front loading problems from high short-term nominal interest rates affect the path of adjustment. Overvaluations can persist for years, and we would judge that real house prices are currently fundamentally overvalued by around 10 per cent. If loan-to-income ratios are reduced then the fundamental overvaluation will increase, and such a policy will put further downward pressure on real house prices.

There is increasing recognition that prior to the global financial crisis financial regulation had lacked a macroprudential perspective. There has since been a strong effort to make a new macroprudential orientation operational, including through the establishment of new macroprudential authorities or ‘committees’ in a number of jurisdictions. These developments raise — and this paper explores — the following three questions. First, what distinguishes macroprudential policy from microprudential policy and what are its key tasks? Second, what powers should be given to macroprudential authorities and what should be their mandate? Third, how can governance arrangements ensure that macroprudential policies are pursued effectively? While arrangements for macroprudential policy will to some extent be country-specific, we identify three basic challenges in setting up an effective macroprudential policy framework and discuss options to address them.

Risk-sensitive capital requirements, such as those established in Basel 2/3, and loan loss provisions based on incurred losses or on short-horizon expected losses, increase procyclicality in the banking system. They could, therefore, contribute to fuelling credit bubbles in good times, as rising risks are not properly covered either with capital or provisions, and credit crunches in bad times, as requirements are sharply increased to compensate for the former undercapitalisation and under-provisioning, and banks respond by cutting credit to households and firms. This paper shows that the procyclicality of current and envisaged capital requirements and loan loss provisions is a serious concern. But, at the same time, it can be dealt with using countercyclical macroprudential tools, first, by smoothing minimum capital requirements using a very simple and intuitive formula based on GDP growth and, secondly, by using forward-looking provisions such as the Spanish dynamic provisions, a working macroprudential mechanism for more than a decade and a full lending cycle.

Global banks are changing. With a new set of rules come new business models. We review the international dimension of the financial crisis, centring on cross-border losses and cross-currency funding problems that prompted authorities to adopt wide-ranging rescue measures and liquidity operations. Against this background, we proceed to examine the regulatory response, focusing on the Basel III framework and the ongoing work of the Basel Committee and Financial Stability Board regarding the amount of capital banks are required to hold, restrictions on maturity transformation on banks' balance sheets and proposals to mitigate the risks posed by systemically important financial institutions. Our conclusion is that capital and liquidity regulation will have distinctly different effects on the international organisation of banks. Liquidity regulation, especially when applied locally, has the greatest potential to reshape the global banking landscape.

Banks within Europe have become larger and more international as Europe has moved towards a unified financial services market, but this trend has been reversed since the crisis. In order to establish the effect of these structural changes on output in Europe, we use a micro data set to investigate the impact of size (as measured by asset size) on banks' net interest margins. We show that larger banks offer lower borrowing costs for firms, which raises sustainable output. We then use NiGEM to look at the impact of banks becoming smaller and moving back into their home territory. We investigate the impacts on output according to country size, showing that the effects are generally larger in small countries, and also larger in economies that are more dependent on bank finance for their business investment decisions.

Low levels of bank capital and liquidity in combination with ongoing crises in other countries are shown to increase the probability of banking crises in OECD countries. Hence global coordination of regulatory reform is vital for reducing crisis risks.