As elsewhere, a regulatory regime of constrained discretion has given way to one with too much unconstrained indiscretion. This calls for regulatory repair. Without change, the current regulatory system risks suffering, like the Chicago teachers and the LIBOR fixers, reputational damage. Fortunately, there are early signs that regulatory change is afoot to place tighter constraints on this (in)discretion. The emergence of self-regulation To understand how we ended up here, it is useful to explore the historical contours of the regulatory debate. This is a history in roughly four chapters. Chapter 1 covers the period prior to the agreement of the first Basel Accord in 1988. Until then, a patchwork of national regulatory frameworks for capital adequacy operated. Some countries set capital adequacy standards based on simple measures of bank equity to assets – a leverage ratio. Others, including in the US, used risk-based standards with risk weights set by regulators for a small set of asset categories. Chapter 2 begins with the introduction of the Basel Accord. This was a landmark agreement: the first-ever genuinely international banking accord, based around an 8% bank capital ratio, with internationally-set risk-weights applied to a small set of banks’ assets. The Accord was explicitly designed to lean against an international “race to the bottom” in capital adequacy standards (Goodhart (2011)). It also helped ensure a level international playing field. Chapter 3 commences with the Market Risk Amendment to Basel I in 1996 and continues through to the Basel II agreement of 2004.
For that reason, they became relevant for our monetary policy. 2  BIS central bankers’ speeches  The role of domestic inflation These global factors, however, have by no means been the only force driving disinflation in the euro area. If we decompose inflation in the euro area and the United States, a striking difference is that, at least until the start of this year, domestic factors explain a much more important part of our disinflationary trend (Figure 3). This stronger role for domestic forces in the euro area has contributed to core inflation diverging from some other advanced economies. It has hovered consistently around 1% since mid-2013 (Figure 4). The ECB’s objective is headline inflation, and there are good reasons for this, not least to keep purchasing power stable. Headline inflation is also a better predictor of short-term inflation developments. But core inflation has to be taken into account because it is more closely linked to medium-term inflation trends. In fact, ECB staff analysis shows that core inflation is a better predictor of medium-term headline inflation than headline itself. Persistently low core inflation is therefore a risk to our mandate. So why have domestic factors affected inflation more in the euro area? The main reason is that, from 2011 onwards, the euro area experienced a sovereign debt crisis and a double-dip recession, while other advanced economies recovered (Figure 5). That led to a very prolonged downturn, which was associated with a decline in employment, depressed wage growth, and low business and consumer confidence.