The financial crisis that started in mid-2007 enveloped the world economy and caused a serious recession in most OECD countries. It is widely believed that it has also left a scar on potential output because it will have raised perceptions of risk and hence reduced the sustainable capital stock people wish to hold. It is inevitable that policymakers should ask what can be done to reduce the chances of this happening again, and it is equally inevitable that the banks would answer that it is too costly to do anything. There are four questions one must answer before it is possible to undertake a cost-benefit analysis of bank regulation. The first involves asking what are the costs of financial crises? The second involves asking what are the costs of financial regulation? The third involves asking what causes crises? The fourth, and perhaps the most important, involves asking whether regulators can do anything to reduce the risk of crises? Our overall approach to these issues is spelled out in a report written for the FSA in the aftermath of the crisis (see Barrell et al., 2009).
