The Banking Crisis of the New Millenium – why it was inevitable.


Under the new theory of financial regulation developed by this author, collapse in the US financial system was inevitable. Removal of protective measures accompanied by failure to increase prudential measures, accompanied by conflicting State/Federal relations, barriers to entry to the real estate industry, together with regulatory confusion resulting in regulatory arbitrage, set the scene for not only erosion from within, but for transnational crime to destabilise the entire fabric of the world financial system. Understanding causes helps in rectify the financial architecture. This article after detailing the enormous numbers of regulatory models that can exist, outlines formulas to assess the type of regulatory model that should be imposed on a system, after assessing the stage of economic and social development.

1. Introduction

Today we are greeted everyday in the media with common excuses for the GFC (the Global Financial Crisis). We admit a lack of prudential supervision and blame laissez-faire capitalism. However we never admit to the major flaws in the regulatory structure as well as the political philosophy of the largest world economy that has almost destroyed a decade of progress.

The fact that not only in the USA have State Governments been left to administer the originators of mortgages and credit default swaps, but the Federal Government has never complied fully with the Financial Action Task Force money laundering provisions. By not complying they have created the ability to abort such legislation using cross-border transactions and complex financial instruments. In addition not only was the implementation of Basel II lobbied against by US financial interests since 1999 and never instituted in the US financial system, which could have highlighted the overlending to the residential mortgage market, but since 2003 SEC recommendations to control the hedge fund industry were never instituted.

A further flaw in the US market is the fact that their real estate industry is not subject to market forces and that the tax system can encourage overborrowing. For instance in Australia the buyer pays no premium to a broker to find a property. All fees are negotiable and rarely go above 2%, not the 6% that is paid in the     USA.     In Australia real estate agents can offer properties nationally and are subject to Federal legislation. Overseas buyers can buy in subject to certain requirements – for instance properties below A$400,000 are protected, and overseas investors in the unit/apartment market cannot buy second hand real estate. Moreover the exemption from capital gains tax, but the non expensing of interest on home loans against income, encourages owners to never walk away from their homes. Australian banks must prove default and cannot advertise a home merely on what is owed. They must auction and seek a fair market price from an arms length buyer.

The contribution of this article is to discuss the types of regulatory models that exist, how they should be adapted to each individual country’s stage of economic and social development and finally to make recommendations as to the appropriate design to correct existing  flaws in the US regulatory model that have spread the crisis that developed in its core banking units worldwide.
2. Behind the Veil and Lessons that Should Have Been Learnt

Systemic failure in advanced not just emerging nations is now an ongoing problem. Hence more than ever we need to define regulatory failure, analysing its causes and develop methods of measuring its severity in order assess how much and when governments should intervene.
We also need to develop an understanding of the vast range of regulatory models through introduction of a taxonomy, which will aid in the selection of methods for early diagnosis and prevention. It is remarkable that I should have been writing in this area for many years, have lobbied governments and regulators, was invited on 2nd June 1999 to the announcement of Basel II, but then witnessed governments ignoring the regulatory literature which predicted the GFC (Currie,1997,1998,2000,2001,2005a,2005b,2006).

The lessons that should have been learnt from the past financial crises (see Caprio et al, 1997, 2003 for a list of such crises) were the necessity for a staged approach to deregulation of protective measures, accompanied by, an integrated, enhanced and even approach to the development of prudential supervision and the establishment of an early warning system.

The evolution of financial services sectors in advanced and emerging nations has been marked by a change in the regulatory model from one dependent on protective measures to one more reliant on prudential supervision. What was necessary to adjust such models for the following factors -

  • The growth of financial conglomerates which demanded coordination amongst different regulatory bodies and levels of government and also meant that regulation, whether prudential or protective, must concentrate on ALL financial institutions. The failure of the US government to adjust its model after repealing the Glass-Stegal and McFadden Acts, meant that highly leveraged investment banks and insurance companies could bring major banks to the point of extinction as described in Table 1 (Source: WSJ, 9/23/08).
  • Unregulated non bank financial institutions (NBFIs) by offering a regulatory black hole have now been proven to provide a home to the new transnational criminal. Witness the Ponzi schemes now uncovered. Mortgage lenders, hedge funds and unregulated finance companies have spread financial risk and promoted contagion.

Investment banks were allowed unprecedented levels of borrowings - Bear Stearns was levered at 31:1, Lehman Brothers 34:1, Fannie Mae/Freddie Mac at .45:1, Merrill Lynch at 46:1, Goldman Sachs at 26:1, Morgan Stanley at 20:1. None of these investment banks complied with Basel II capital adequacy requirements and were geared far more than the normal on-book average of 22:1. This is why many of these investment banks disappeared as described in Table I.

Why has regulatory failure occurred in 2007-9 and spread to a Global Financial Crisis. Causes lie not only in laissez-faire capitalism, but also in accounting rules such as mark to market which promoted the idea that huge profits could be recognised before realised by churning non liquid assets. Contributing to this quagmire was regulatory confusion between State and Federal legislation, lobbying against controls on residential lending, and flaws in the literature on regulatory failure which took no account of the present stage of development of an advanced economy. This translated into the lack of recognition that advanced economies had not adjusted their regulatory models as their economic and social infrastructure underwent some profound changes.

Table 1: Investment banks that disappeared 

The transformation of Goldman Sachs and Morgan Stanley

Where the system has been liberalised and globalised, where insurance, funds management and banking activities have been merged, regulatory failure can occur in not just the traditional banking industry but in insurance, by virtue of either cross linking guarantees or the effect on confidence. Consider also the regulatory confusion created by too many regulatory bodies and State vs Federal controls. Regulators failed to recognise the problems of insurance companies selling credit default swaps being supervised by State bodies who were also allowed to supervise without appropriate Federal oversight the sale of mortgage backed securities (MBS), not only across State borders but across countries.

3. The Role of financial institutions in regulatory failure

Causes of bank crises range from lack of investor and depositor confidence precipitated by the perception of a  deterioration in asset quality. The latter is most commonly caused by excessive industry, product, country risk concentration, or intergroup lending all resulting from lack of credit control, lack of sound lending policies and lack of internal control procedures checked upon by external auditors and the central bank supervisors. Apart from asset quality, large diversifications into new areas of business where the institution lacks expertise, are reasons that financial institutions as well as corporates get into difficulties.  The risks in overtrading in banks where either the foreign exchange positions are not controlled or the option writing not fully appreciated is enormous, and spectacular losses have been made by banks in these areas. Another classic failing of financial institutions is liability mismanagement.

Within this framework of causes of bank crises, fraud is the most difficult for the bank analyst to predict. It is not impossible not to see fraud playing a role in the entire business of toxic assets.

But the question arises of how to measure the seriousness of a financial crisis caused by regulatory failure before firstly prescribing the medicine, and secondly before taking corrective action to adjust the regulatory model to prevent a repeat.

4. Measurement of regulatory failure

The effectiveness of regulation and its corollary, failure, could be measured against measures of stability such as exits and failures of banks, when the reference is to winding up, or sale due to insolvency/ It can also be measured by a lack of community confidence in banks or by a  weakened banking system beset by poor profitability and low capitalisation, and stakeholder losses, (OECD, 1992).

Alternatively a microeconomic approach could be used by regulators based on agency theory which justifies measuring risks from balance sheet ratios. This allows assessment of how well the interests of depositors, investors, customers, creditors and regulators have been satisfied as to the appropriate bank behaviour in managing the four principal risks that can threaten the stability, safety and structure of the financial system - namely credit risk, liquidity risk, interest rate risk and leverage risk. Also used is the assessment of investing and financing patterns, and dividend and executive compensation ratios

5. Meaning of regulation, deregulation and liberalisation

What is clear is that we need a definition of the severity of regulatory failure which can result in financial crises. Costs and benefits of regulatory failure or its opposite can be redefined in terms of new microeconomic indices of bank performance, and macroeconomic indices of economic and social development (see Bordo et al, 1993).  The scale to measure regulatory failure proposed in this paper is an arithmetic scale from 1 to 10 where the series represents an escalation in severity as follows:

  1. Volatile security and asset prices, resulting from failure by central banks to target inflation and prudentially supervise the risk behaviour of financial institutions,
  2. Failure in major corporates, and/or a minor bank and/or a major non bank financial institutions,
  3. Removal of funds from minor banks and/or non bank financial institutions to major banks or to alternative investments such as prime corporate securities,
  4. Removal of funds from corporate securities to major banks, precipitating further volatility or at worst a stock market crash,
  5. Removal of funds from major banks to government guaranteed securities, such as postal savings accounts in Japan,
  6. Flight to cash and or gold,
  7. Contraction in lending leading to lower economic growth, disruption to savings and  investment,
  8. Failure in major non financial institutions, and  failure in major non bank financial institutions,
  9. Failure in major banks,
  10. All of the above together with a currency crisis leading to rapid depreciation, rescheduling of external country debt, higher inflation and negative economic growth.

Despite defining financial crises according to the OECD (1991) schema and using the above scaling of crises, a new theoretical framework is needed to aid in the prevention of such crises. The debate re regulation dates back to the seventies – see Mitnick (1970). Deregulation does not necessarily mean the absence of regulation. Different methods of deregulation can be used. Formal deregulation which is planned can occur in four ways - .guided or unguided wind down; disintegration with transfer of programmes; stripping of functions and a catastrophic ending. In assessing how to change regulatory models we need to distinguish between prudential and protective measures. What will assist in the discussion of why the regulatory model in the USA imploded and exploded is an understanding of the vast range of regulatory models that can exist. The author developed such a model as part of understanding why the Australian system nearly collapsed in 1991, calling for  a supra regulator both nationally and internationally in an inquiry held in 1991-2 (see the Martin Inquiry, 1992). This taxonomy is explained in the next section.

6. The Taxonomy for classifying financial systems

This taxonomy (Currie, 2000) distinguishes between Prudential Supervisory Systems, which have different methods of Compliance Audits (strong and weak), Sanctions (strong and weak) and Enforcement Modes (seven types) and Protective Measures (institutional vs discretionary in various weak/strong combinations). These permutations and combinations give a total of 140 models ( 2x2x7x5 = 140).

Enforcement Modes range from conciliators to strong enforcers, representing a scale from weak to strong.  Conciliatory modes are ones where law enforcement is rejected and conciliation is used to resolve disputes. Benign Big Guns are modes whereby enormous power is given in terms of confiscation, takeover of activities, seizure, increasing operational rules, banning of products. Powers are rarely used - the threat is sufficient. This model has been called "regulation by raised eyebrows" or "by vice-regal evasion" (Grabosky and Braithwaite, 1986). Diagnostic Inspectorates are modes where supervision is carried out by encouraging self-regulation by well qualified inspectors detecting non-compliance. The goal is a co-operative relationship.

Token Enforcers uses enforcement modes  where co-operative and self-regulation is not important. A Detached Token Enforcement mode is more rule-book oriented, training staff, prosecuting more, seizing assets, targeting repeat offenders.  Detached Modest Enforcement involves rule-book inspections, steady flow of prosecutions, with modest penalties.  Strong Enforcers use all forms of enforcement licence suspensions, shut down of productions, injunctions and adverse publicity, as well as high penalties.

Sanction types can be industry based whereby there is consultation re appropriate preventative measures, discussion papers with written and oral input sought from industry via the Exposure Draft process, imposition of codes of conduct, imposition of direct controls, such as new prudential ratios, new interest rate ceilings, new reserve ratio rules, new capital adequacy rules, changes to Competition laws, cooperation with sister agencies to initiate prosecution to establish a precedent, changes to licensing rules, changes to banking laws, enforced divestitures or acquisitions (for instance of non bank financial institutions) on an industry basis, and finally nationalisation of the banking industry. Sanction types can also be firm based. The broader part of the first firm based pyramid of sanctions consists of the more frequently used regulatory sanctions - coaxing compliance by persuasion. The next phase of enforcement escalation is a warning letter followed by imposition of civil monetary penalties, then criminal prosecution, plant shutdown or temporary suspension of a license to operate. Each stage is only followed if there is failure to secure compliance. At the top of the firm based enforcement pyramid of sanctions, there is permanent revocation of licenses.

Knowledge by a firm of the enforcement pyramid actually increases the effectiveness of the enforcement. If a banking regulator only has the drastic power to withdraw or suspend licences as the one effective sanction, it is often politically impossible and morally unacceptable to use it. Withdrawal of a licence involuntarily in banking would result in that bank losing the implicit or explicit guarantee of the central bank, with a likely bank run or cessation of activities, resulting in possible contagion effects.

Hence an incorrectly designed regulatory model can create a paradox of extremely stringent regulatory laws at times resulting in a failure to regulate. The design of the regulatory sanction pyramid should ensure that the information costs to the regulated firm of calculating the probability of the application of any particular sanction acts as a barrier, and that there are sufficient politically acceptable sanctions to match escalations of non compliance with escalations in sanctions by the state (Ayres and Braithwaite, 1992, p. 36).

Compliance Audits range from Weak to Strong and can be applied at Firm or Industry Level. Firm Level compliance audits consist of offsite examinations only using information supplied by the bank itself plus audited accounts, supplied by company appointed auditors. External (company appointed) auditors then should supply additional data and report directly to the central bank if they are concerned regarding a bank’s risk management. Note that this system includes no method of monitoring or controlling company appointed auditors in the event of deliberate or unintentional errors in their reports. In addition pre arranged onsite inspections of certain risk management aspects of a bank by regulators and/or by Banking Law auditors can be organised by the central bank or can also arrange surprise or spot inspections to check a bank’s risk management  by Banking Law auditors who can liaise with Company Law auditors. A further escalation of concern would involve surprise onsite inspections of all aspects of banks’ risk management systems, when auditors are appointed by the central bank, not from the same firm as the banking law auditors, or the company appointed auditors. A higher level would involve surprise onsite inspections but with reports only going to the bank and central bank. The top censure would involve published reports. Industry Compliance Audits involve industry hearings to check on best practice and to bring banks into alignment (the best most recent example is the examination of the managing directors of the eight largest banking firms in the USA on 11th February, 2009). Special reports can be commissioned by government using outside consultants, governments can  initiate inquiries at which evidence is sought form the public, Royal Commissions can be held presided over by a Judge or appointed by the government and finally a commission presided over by a specialist appointed by an outside agency eg. The BIS, or the OECD or the IMF), or presided over by another country (For instance the Niemeyer Commission in Australia post the Great Depression and the Royal Commission into the collapse of HIH Insurance Group in 2001).

Protective Measure Types are usually all industry based  each type of protective measure has a range of weak to strong arrangements. Discretionary measures  involve safety net schemes, apart from deposit insurance schemes. Safety net schemes can include one or all of the following. If all are included the regulatory model or system is becoming increasingly stronger: implicit or explicit guarantees, special shareholder liability, regulatory intervention, both to ensure depositor protection and to prevent runs. Liquidity support arrangements comprise policies towards lender of last resort and towards the cheque clearing accounts that most banks hold at the central bank (known as Exchange Settlement Accounts). Activity restrictions were an old way of moulding bank behaviour such as restrictions on permissible activities, restrictions on branching, restrictions on equity holdings, regulations creating market segmentation, interest rate caps and floors imposed on borrowing and lending, restrictions on interlocking directors, restrictions on banking conduct, through either a voluntary or legislated code of conduct. Institutionalised measures include disclosure regulations, such as secrecy provisions regarding client details as well as rules relating to what information a bank must publicly disclose. There are two types of information demanded - reports to regulators, such as the central bank, a banking ombudsman, and reports to shareholders, which are lodged with a companies and securities regulators and also available to other stockholders, such as depositors and consumers. Institutionalised Deposit Insurance Schemes, can range from weak versions using private insurance, flat fees, partial coverage, unfunded, voluntary to the strong version which is a public scheme, charging risk related fees, offering full coverage, being fully funded and compulsory. Each type of protective measure has a range of weak to strong arrangements, but an appropriately designed regulatory model is thought out in advance and designed to match the economic and social development of a nation (see below). The worst mistakes are made by suddenly changing the model in response to an emergency. For instance in Australia the sudden introduction of a deposit guarantee on all deposits and borrowings by Australian banks caused not only a run on mutual funds, but a flight of foreign banks from Australia as they could not raise funds as cheaply as their Australian counterparts.

When such controls are removed whether protective or prudential, and whether by intent or neglect, such a phenomenon is known as deregulation. It can and has had some different outcomes ranging from :

  1. Return, risk and efficiency measures  remaining the same;
  2. Return measures increase but so do risk levels but not to a level to threaten systemic stability, while efficiency measures  decline but not to a dysfunctional level; or
  3. Return and risk decline, while efficiency measures improve;
  4. Return measures decline, risk level increase while efficiency deteriorates.

Obviously the fourth outcome is suboptimal. Which is why we need a new theory of financial regulation.

7. The need for a New Theory of Financial Regulation

Why do we need regulation? Advanced nations have experimented with a total loosening of all types of protective and prudential measures and have learnt the old lesson – that regulation is required to promote a stable economic structure in order to prevent the price and output volatility that can lead to financial crises. Regulation is multi-faceted and also involves establishing a regulatory model the role of which is to contain and mould the risk taking and management behavior of both financial and non financial institutions as well as market participants through prudential supervisory systems appropriate to the strengths or weakness of the protective measures.

How then to design a model appropriate to a particular country’s circumstances? This author suggests a “A Four Factor Interactive System” which  assumes a central role of financial institutions. The design of the regulatory model, called the M  factor, must be taken as a starting point to the promotion of an economy and society up the development scale. The exact components of that model in terms of protective and prudential measures must be specified. It is postulated that there are three other factors - C, O and H. These are necessary to the achievement of economic and social development in an emerging, transition or advanced nation, but they are not sufficient without  interaction which requires a feedback mechanism or adjustment process between the components of the envisaged system. This feedback mechanism promotes the advancement up a scale representing the degree of development of all four factors.

In the model  outputs represent Y1 = economic development, defined as sustainable growth which can be measured at the level of the individual by the increase in a maintainable and stable level of income per capita, at the corporate or institutional level by the increase in a maintainable and stable accumulated earnings per capita, and at the country level by improvements in the ratio of external debt and current account balance to Gross Domestic Product (GDP), as well as increases in the level of maintainable and stable GDP per capita . A further output is Y2 = Social development , defined as growth in the equitable distribution of wealth, which can be measured by the dispersion and distribution of per capita income, and participation in institutions, which could be measured by a scale ranking the democracy of the government of a country.

Inputs are the legal infrastructure – competition, bankruptcy, commercial and criminal laws, with legislative barriers to entry and exit to the finance sector to promote stability, measured by the Compendium of Standards. This is the C factor. Another input is the structure and pattern of ownership of both financial and non financial institutions - the O factor, which requires a knowledge basis for understanding the rights and obligations of ownership, and leads to demand led investment in education. The quality of human capital, in terms of education, knowledge and skills is also vital. In this theory human capital or the H factor, involves not just increasing the capacity but learn, but enabling the individual to participate in a financial system so that social and organisational capital, or the interrelationships and systems for mediation and dispute resolution, can be adapted to increasing stages of development.

The importance of Ownership structure to the financial system cannot be overemphasized. Wide spread ownership creates synergy between shareholders, bondholders and depositors interests. Concentration of the banking sector is also proven to promote stability. Changing ownership structures can be achieved through employee share ownership trusts, privatisation with shares issued to employees, and through the increasing role pension or superannuation funds, publicly listed funds, community and family groups. The necessity for the O factor lies not only in the improvements to efficiency and removal of political intervention (OECD, 2000), but also in the promotion of participation in adapting a development strategy to the needs and capacities of the underlying economic and societal systems (World Bank, 1998). Participation is required to build consensus and induce change from within (Stiglitz, 1998).

Within this model there are certain Constraining Factors. Government goals (G) influence the development of M and O. That is, they are policy dependent factors. There is also the E factor, or the starting set of economic resources and infrastructure, both developed and undeveloped, influence the attainment of economic growth and social development by limiting, influencing and constraining C and H.
The new theory of financial regulation thus conceives of a national economy as set of interrelating systems and subsystems which can be described in terms of a set of equations as follows:

(1) If Government Goals or G = X1 = f (S, S, S, Co, Cf) where the terms safety (S), stability (S), structure (S), convenience (Co) of users of financial services (such as access to a product or service) and confidence (Cf) is general public confidence in the financial system.  These terms are adapted from Sinkey’s (1990) theory of regulation and
(2) Economic Resources or E = X2= f (D, FDI, K, A), then
(3) Economic Development or Y1 = M (X1). C (X2), and   
(4) Social Development or Y2 = O (X1). H (X2)           

The availability of economic resources to devote to economic and social development will depend on government funding which may require deficit spending (D), direct foreign investment (FDI), private capital formation (K) and foreign aid (A).

Can this model be used to describe what is happening now and whether there are leakages from the system? The convention against Transnational Organised Crime (2001), also known as The Palermo Convention non-exclusively defined  transnational crime to include money laundering and computer related crime. However the use of derivatives and non regulated institutions is an area into which organised crime has and can move. Sub-prime criminality in the sub-prime crisis included fraud by brokers or borrowers; unscrupulous underwriters, brokers and financial planners who copped a sling from pushing through questionable mortgage applications; originators who exaggerated assets & income or concealed liabilities & out-goings and a proliferation of Ponzi schemes. Many of the lenders that have produced toxic assets or sub-prime loans were non bank financial institutions (NBFIs) whose success was measured by loan throughput.

Consider also the fact that many of the hedge funds, and other NBFIs use tax havens as their corporate base means that the checks and balances on them to ensure they are not being used by transnational criminals is deficient. 46.7% of funds are domiciled in the Caribbean according to the Global Data Feeder.

Despite legislation prohibiting its bankers from assisting in the flight of capital and tax evasion, Switzerland still rates as a safe haven for ill-gotten gains – in every crisis funds leaving a country for Switzerland will cause currency depreciation of the exit country and appreciation in the tax haven

8.0 Conclusion: A Regulatory Black Hole

Actions taken to date to relieve the crisis apart from stimulus packages and direct aid to banks, include open market operations to ensure member banks’ liquidity; Central banks reducing interest rates charged to member banks for short-term loans; re-examination of the credit rating process; muted regulatory action on lending practices, possible reforms to bankruptcy protection, tax policies, affordable housing, credit counselling, education, and the licensing and qualifications of lenders; future amendments to disclosure rules and promotion investor education and awareness and public debate.
However in 2003 the SEC recommended when reviewing hedge funds certain actions which are still not implemented.  They included

  • Registering Investment Advisers under the Advisers Act, with strict disclosure requirements;
  • Introducing Standards on Valuation, Suitability and Fee Disclosure Issues relating to registered fund of hedge funds (FOHFs) such as those that placed monies with Madoff;
  • Limiting general solicitation in fund offerings to qualified purchasers;
  • Ensuring the SEC and the NASD monitor capital introduction services provided by brokers;
  • Encouragement of unregulated industries to embrace and further develop best practices.

So there is obviously an urgent need to review why the SEC not only was ignored in its recommendations for investors advisors, but why the Federal Reserve did not object to State governments supervising mortgage originators and the writers of credit default swaps such as AIG. Why also the number of regulatory bodies which allowed regulatory arbitrage was never reviewed and integrated supervisors established as in Canada, Europe, Australia and the UK. Why also was Basel II lobbied against when it would have brought to an abrupt standstill the excessive concentration on mortgage lending in the US financial system. Why also was the banking industry but not the real estate industry allowed to  deregulate. Why the US has never completely complied with money laundering rules. Why the accounting standard of mark to market (FAS 157) has never been reviewed when it allowed both incredible write ups and disastrous write downs. The list is endless but there is an obvious need to redesign the US regulatory model from scratch.

So how should  this be done? A detailed method is described in Currie (2005). In essence this involves assessing the existing system in terms of inputs and outputs given constraining factors and then considering changes not only in terms of the regulatory model and its components, but also in terms of  the existing human expertise and how it is motivated (note the dysfunctional effect of incorrectly designed executive compensation was one of the conclusions of my thesis reaffirmed by Bank of England studies – Currie, 1998), and also in terms of the legal infrastructure, government goals and starting economic resources. Just as Australia found a flawed Federal system responsible for regulatory black holes, so too should the new US government re-examine its entire regulatory model in terms of this new theory of financial regulation.


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