Financial regulation: facing a global challenge

Photo André Lévy-Lang / Chairman, Institut Louis Bachelier / May 9th, 2011

The regulation that followed in the wake of the financial crisis has only partially addressed the challenges exposed by the collapse. Restrictive measures on equity levels and liquidity requirements have been taken but have been restrained by fears over endangering the very instruments necessary to finance the fragile recovery. The need for a global framework, and a more explicit separation of market and credit risk, would complete the picture as would reinforcement in scope and power for the bodies charged with enforcing the new regime.

The need for an overhaul in financial regulation has been largely accepted both at the level of individual states as well as international bodies (G20, EU, the Basel club, etc.). The received wisdom is that the surest way to prevent any future collapse, or at the very least place limits on its size and scope, is to analyze the most glaring structural weaknesses that contributed to the recent crisis. Popular sentiment has lent the process a punitive flavor and the proposed corrective measures have largely adhered to this logic with a nod to the financial sector’s role in leading the world economy to the brink of collapse through a combination of greed and incompetence.

One example of the approach is the mountain of legislation contained in the 2319-page Dodd-Frank Act which President Obama signed into law in July 2010. The G20 has created its own Financial Stability Board to help guide policy in the sector and the Basel club has continued its leadership role of the past 20 years through the publication of a new set of banking regulations known as “Basel III.” EU policymakers are finalizing a new set of directives for the financial sector and have gone a step further to include insurers. Reading between the lines of the various initiatives we can trace the outlines of the legislative and regulatory framework that will define global finance for the next decade and clearly a balancing act will have to occur in order to ensure adequate safeguards are implemented without placing limits on overall effectiveness.

A brief reminder of the fundamentals of the financial sector will shed greater light on the current dilemma and we must ask ourselves: Why is finance necessary? Why should it be regulated? For what objectives?

The financial sector serves society by providing the tools to unlock the potential of capital as an engine of economic development. Finance allows for economic resources to be efficiently distributed and creates benefits in the form of increased investment, increased economic activity and improved ability to manage risk; in simpler terms, more growth. This process of optimization is universal and has played an essential role in global growth over the course of the last 30 years. On balance, despite the recent crisis, the overall effect of finance has been largely positive.

The financial sector has a number of tools at its disposal and regulatory regimes are for the most part created to ensure they function correctly within a coherent system. More concretely:
- A process of financial transformation occurs. In the case of banks this involves the transformation of short-term funds (primarily deposits) to finance long-term investments (loans, treasuries). The cost of long-term debt financing is reduced through an act of financial transformation because short-term funds are typically cheaper than long-term ones. Additional benefits accrue as the process boosts the volume of long term investments that would otherwise be limited to the availability of long-term savings.
- Leverage is harnessed by bankers as well as insurers and consists in maintaining relatively small levels of equity in relation to total assets, typically around 8%. Leverage magnifies return on equity : In rough terms, a 1% net margin on assets translates into a 12% return on equity if equity finances only 8% of total assets.

The combination of financial transformation and leverage creates powerful mechanisms through which the financial system, banks and insurers, can meet the needs of the economy as much in terms of financing investments as in providing adequate insurance against risk, without freezing up excessive amounts of capital.

The viability of banks and insurers depends on integrity and confidence between depositors and bank creditors, clients, and insurers. The effectiveness of financial transformation and leverage depends on corresponding levels of trust.

Trust is what economists would define as a “public good,” meaning goods that can be consumed by everybody in a society and for which nobody must pay directly. One commonly cited example is clean air and regulatory bodies exist to ensure a measure of control over levels of atmospheric pollution. A similar system is necessary to ensure the healthy functioning of the financial system which is as much a public good as the air we breathe. The framework must limit abuse as occurs when a financial enterprise becomes excessively leveraged (through a lack of equity in relation to total assets) or is subject to excessive transformation (experiencing shortfalls in the liquidity necessary to meet the demands of creditors). The downfall of Lehman Brothers is directly attributable to a lack of equity while Northern Rock’s demise was precipitated by its inability to survive a drying up of liquidity.

Banks were at the center of the recent crisis (insurers represented a lesser risk as they are not as dependent on short-term funds) and from the preceding outline we can infer the outlines of a future regulatory framework which will focus on limiting the potentially toxic effects of leverage and financial transformations. The two principal instruments of policy will likely rest on increasing capital requirements for banks and stress-tests to ensure the ability to withstand any future shocks in liquidity brought on through excessive financial transformations. Readers will note that these two recommendations are directly related to the specific tools which best allow banks to respond to the needs of the main economic actors, thereby encouraging growth.

Herein lies the rub of the regulatory dilemma surrounding banks in the aftermath of the crisis. Policymakers and financial professionals are so caught up in the debate over how to improve the tools that got us into the current mess that they have largely ignored other equally important aspects of financial regulation. If we are unable to see beyond capital requirements and liquidity buffers we could be led to yet another set of false conclusions over the security of the system.

Now would be a good time to remind ourselves that financial regulation has remained largely a national concern and responds to domestic prerogatives at the level of laws and their application. Developments in our global financial system have largely outpaced a rather sclerotic regulatory framework, which by its very nature is unable to keep up with rapid evolution in the markets.

An initial attempt at a coordinated approach toward regulation dates from 1988 when central bankers came together in Basel and convened the first ever initiative to issue joint recommendations on capital requirements for international financial institutions based on the Cooke ratios. These principles, named after the founding father of the Basel Committee on Banking Supervision, were to be implemented globally under what soon came to be known as Basel 1. A number of years later a second series of core principles of banking supervision which came to be known as Basel II were introduced. The latter directives were an attempt to account for the rapid evolution of global markets by creating a new system to address minimum capital requirements for worldwide banks. The next stage of the process arrived only recently with the Basel III initiative which has integrated lessons learned from the most recent crisis.

The primary concern for regulators, from the moment of the first announcement in 1988, has been to avoid any danger of a domino effect where one bank failure leads to a series of others dragging down one institution after another in an increasingly interdependent international banking environment. In the beginning it was the highly leveraged Japanese banks that were identified as the primary source of systemic risk due to lax standards in the country’s regulatory bodies who were far more concerned with boosting the bottom line and conquering international markets. It would be hard to forget the reaction of a number of my eminent colleagues when confronted with, often for the first time, the mathematical relationship between borrowing costs, capital ratios, and profitability …

The recommendations of Basel I were both necessary and effective but as with any new regulation unintended consequences quickly arose during actual implementation. While there were many positive outcomes some policies created distortions which led directly to our current crisis:

- Securitization and disintermediation: By mandating that banks fulfill minimum capital requirements, Basel I had the unintended effect of encouraging a rapid increase in off-balance sheet transactions that eluded regulatory oversight, as they did not actually freeze up any of the bank’s equity. Increasingly, markets were seen as the ideal solution in the search for new ways to finance economic growth, directly or indirectly, and with heavy reliance on securitization of banks’ loan books. Essentially banks were able to offload credit risk from the balance sheet through the creation of financial instruments which pooled credits into bonds based on the credits cash flow, that could be resold to investors. A significant portion of finance was surrendered to unregulated markets where there existed no obligation to comply with the usual regulatory framework governing the activities of bankers, insurers, and fund managers.
- Credit derivatives are another way for banks to make limited equity stretch even further. Essentially these are contracts to shoulder the credit risk of a third-party. Value is derived from an assessment of underlying risk and a payment is made to insure against the possibility of non-payment. If there is an event such as a default or bankruptcy than a one-time payment must be made in the other direction and the agreement is terminated;
- The failure of rating agencies: By assigning too much importance to the calculation of risk-weights based on ratios of capital and risk the Basel club recommendations place too much power in the hands of ratings agencies. Investors seek out low-risk investments in the form of triple-A rated and sovereign debt which can be held with little collateral.

With banks no longer acting as intermediaries and ever increasing recourse to market-based instruments through securitization and derivatives many of the risks associated with the financial sector escaped the umbrella of banking regulation. The good news was that this allowed for a significant mobilization of capital and greatly contributed to the economic growth of the last 20 years. The bad news arrived with the eruption of the current crisis:

- On one hand, unregulated markets led to abuse as was made plain through the subprime lending crisis, largely precipitated by American lenders operating outside the traditional banking system and financed through securitization with a nod from unscrupulous rating agencies.
- Finally, because of an accumulation of risk outside of official banking channels, and in particular because of derivatives, America’s largest insurer AIG had to be rescued from bankruptcy by taxpayers after it strayed too far from its core business.
- In what is perhaps the most serious indictment of the financial system, the accumulation of risk by certain banks who based their decisions on the triple-A ratings of their investments, when they were in reality purchasing debt based on complex credit derivatives, could lead us to question and indeed fear the recent trend toward investment in sovereign debt, identified as safe by the very same rating agencies…

While this information is taken for granted now, and the roots of the crisis from both within and outside of the banking system are well understood, it remains to be seen whether a coherent regulatory framework for banks can be constructed when so much of the system allowed, and indirectly contributed to, the recent bubble. How can we avoid, or at the very least limit, the next one?

It is completely natural for financial professionals to look for ways around regulatory constraints and it would be an illusion to believe we can eliminate a phenomenon that is often the source of significant innovation. It is a truism that the more draconian the banking regulation the more ingenious will be the mechanisms for shifting financial operations into less regulated segments of the economy. Moreover, excessive regulation, as we have already seen, can place a brake on the ability of financial institutions to act as an engine for growth and limits the effectiveness of banks, insurers, and markets.

Rules on capital and liquidity buffers alone are not enough and financial regulators will have to take a broad view that takes in the potential for risk from both within and without the traditional banking system and accurately assesses the various risks. A degree of subtlety and a truly international scope, as well as the means to finance these twin aims, will be essential to the success of the regulators.

Creating a finely-tuned system to set capital requirements for banks: without going so far as to completely separate investment and commercial banking arms, because of the economic risks this could create for the health of the financial system as a whole, lines could nevertheless be drawn in terms of capital requirements. British regulatory bodies have proposed erecting a virtual Chinese Wall in the form of capital requirements at the heart of the largest commercial banks. Under their proposals, depositor funds with the main retail banks would be more insulated from risks associated with the market than would investment arms. It’s an idea that merits further exploration and would allow us to resolve the moral dilemma that is conveniently sidestepped with the innocuous expression “too big to fail”, the idea being that systemically important financial institutions not be allowed to collapse for fear of taking out the rest of the system.

A more global authority: neither Basel III (nor the similar Solvency II set of rules to govern European insurers), have the international reach to match global financial institutions. While the EU has effectively created the means to govern its own affairs this counts for very little in the United States which remains the largest financial powerhouse. The 2319 pages of the Dodd-Frank Act provide only a partial remedy to the structural weaknesses of the American financial system, so painfully revealed in the recent crisis. The Financial Stability Board (FSB), a global club of regulators established by the G20 countries, has been designed to cope with the friction that arises when divergent national regulatory bodies bump up against each other, and is backed by a secretariat which relies on the rules created by the Basel club (where it is in fact hosted). And this leads us to a third condition, and in my eyes the most important …

Adequate means and high standards in the regulatory ranks: when I assumed the leadership role at a large bank one of my first steps was to establish an essential but largely unwritten rule: risk managers were to be chosen from the best and brightest and would receive compensation, as well as career prospects, that fully corresponded with the importance of their responsibilities. Admittedly, fulfilling this oversight role will be rather harder for public authorities than it has been to implement internally in private enterprise. The financial industry plays an important role in many national economies, one that is sometimes exaggerated when viewed in strict terms of the benefits it provides (look no further than the huge bonuses paid out by Wall Street this year). The financial industry will continue to reward the ‘regulated’ far more than the ‘regulator’. Nevertheless it has become indispensible to the effective functioning of the economy that we have a truly independent body, one that has not been “captured” by the interests of the financial industry. Regulatory bodies should avoid becoming too cozy with those they are supposed to regulate and we must be prepared to commit the necessary resources to ensure it does not occur again.

Both on- and off-balance sheet transactions as conducted by the banking sector are useful in illuminating other corners of the financial world when the right questions are asked. Information exists in abundance and the signs of the most recent crisis were on public display for those who wanted to look and will remain in view for those searching for signals of the next potential financial meltdown. Unrestricted access to the books of the banking sector, and the technical capacity on the part of the regulators to handle large and complex sets of data, are necessary for the FSB to fulfill its mission as an efficient mechanism for effective coordination and processing of financial data.

In conclusion, we can inject some much needed optimism to our outlook with the observation that were it not for the constant amelioration of the regulatory framework over the past 20 years the economic consequences of the financial crisis would have been far more dramatic. What better time than the present to implement further measures to ensure that when the next crisis arrives it is brought under control with rather less pain than was endured under the one we have just lived through?

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