ParisTech Review

ParisTech Review – What’s going on with financial regulation?

Claude Bébéar – Before we start, let me put it in black and white: the magnitude of the financial crisis that started in 2008 fully justified strengthening financial regulation. Significant progress has been achieved: a better matching between capital weightings and the risks taken by financial institutions, a significant improvement of the monitoring system in Europe, etc. This is a crucial aspect that we remind in the report of the Institut Montaigne How to reconcile growth and financial regulation – 20 proposals, published last November.

This being said, finance has become completely international and regulation is extremely difficult to conceive and to implement if not on the global scale. And the problem is, creating a truly global financial regulation is virtually impossible. The new banking standards, called Basel III, provide a good example. The Americans announced that they are not planning to apply it anytime soon. Under these conditions, if a bank agrees to submit to the restrictions of Basel III, it will suffer de facto from competitive disadvantage compared to U.S. banks. A similar problem is also emerging as a consequence of the new insurance regulations, Solvency II.

Will the non-implementation of Basel III give an edge to U.S. banks or will it instigate mistrust among economic players?

Without being too cynical, I’d say they will reap a considerable advantage. In today’s world, what matters most is the value for the shareholder. Financial players generally consider that regulators take superfluous and excessive precautions. Less capitalized banks will be perfectly suitable for investors and borrowers. Being virtuous does not pay off, since virtue is poorly evaluated and poorly formulated by regulators, who aren’t competent in this matter.

If regulators aren’t competent, what other drivers will ensure the stability of the financial system?

Regulators are accountants who have no sense of business dynamics. They have an overly static and superficial view. A poorly capitalized company can perfectly have a very high human and marketing potential, while another company, well capitalized according to prudential standards, will collapse due to a wrong strategy. Ultimately, regulators only take in account apparent capitalization. But what does count is the real capitalization, the dynamic forces, the potential. Investors are clever. They know how to discover and analyze, based on the expected duration of their investment, the specifications of the firm that are important to them. And regulators cannot successfully contain hazards because their work is based on questionable assumptions, whose validity varies over time. The environment can suddenly change and these assumptions become obsolete.

Should we restore some sort of Glass-Steagall Act, the U.S. law that had established in 1933 that a single institution could not be a deposit bank and an investment bank?

To separate conventional credit activity from more speculative activities is a good idea, one that goes in the direction of safety. But then again, there is no uniform regulation throughout the world and the competition will be seriously distorted. Such and such operation will be realized in less severe countries.

Before examining the details of the measures, we need to identify the source of the problem. The main enemy of the economy is speculation. However, all current accounting rules are short-term and thus promote speculation. When you adopt for instance “mark-to-market” (in which, day by day, you record the value of an asset according to its market price) and the so-called “fair value”, that is to say, when a company’s assets are valued according to their market value at the date of the balance sheet, you actually encourage speculation.

If my assets are composed of shares, on any given day, they may be worth a certain price and the next day, another price because the market has changed. It might be in my interest if I’m planning to liquidate my company, but for a company at cruise speed, this accounting method is in no way interesting since this “fair value” does not reflect the development work that has been achieved or that is in course. Some have also considered having a double accounting: the market value for the entities that will be sold during the year and another, less volatile value, for other assets.

Better an imperfect regulation than no regulation at all, right?

Unfortunately, regulators always protect the system against the previous crisis… In the late 80s, the U.S. underwent the “junk bonds” crisis, mixed with a housing crisis. Suddenly, the insurance companies were forced by the regulator, under the pretext that they invest on the long term, to reduce drastically by 30% the estimated value of their shares and real estate. As a result, they stopped buying properties and shares. After this decision, investment funds were ready for take-off and began to purchase real estate and shares abandoned by insurers. Funds were allowed to use “mark-to-market” accounting rules because they were competing with short-term speculators. Here we clearly have a situation where regulators contributed to the next crisis because they left shares and properties in the hands of speculators, while insurers would have brought much greater stability to this class of assets. Under the pretext of containing the speculative danger, regulators substituted wise and cautious investors by… speculators.

So they created the next crisis?

The financial crisis of 2008 was due to the inconsistent and contradictory logics of financial regulation. Numerous mistakes were made. Regulation excluded from its scope the riskiest markets that prospered in non-regulated niches. The Basel Agreements were designed to implement prudential regulations for banking activity, by improving risk management. Through securitization, banks have intended to eliminate this risk by disseminating it in the non-regulated financial markets, with unregulated operators.
Banks have taken over the risk by financing unregulated operators and unregulated operations with very high leverage at multiple levels. The risk has become too complex for a genuine assessment and has become virtually untraceable. It became so condensed that is was reintegrated within the activity of banks. By allowing structured investment vehicles, the regulator actually contributed to overlooking these risks.

In addition to official regulators, rating agencies are expected to provide reliable information to the market.

These agencies have played a devastating role during the crisis. Firstly, they were unable to anticipate. This is not new: in 2001, Enron and Worldcom were rated in the “Invest” category a few days before their bankruptcy. Second, rating agencies have a strong tendency to overreact once the crisis is recognized. By downgrading repeatedly Portugal, Ireland, Spain and Italy in 2010 and 2011, agencies have mechanically complicated their debt emissions and weakened all economic actors within these countries. The EU has addressed this issue and is now attempting to regulate the activity of agencies. But the real problem is that by gradually integrating ratings in financial regulations, regulators have completely disempowered investors. We must “detoxify” ourselves by removing ratings from financial regulations. This is what we show in an Institut Montaigne paper, “Putting back financial rating to its right place”, published last summer.

Is it impossible therefore to organize global finance?

Today, the real risk is that of an excess of inadequate regulation as a result of knee-jerk legislative responses to the crisis. Drowning financial institutions in an ocean of unnecessary and costly procedures will not remove the danger: it will only achieve restricting credit. There is no miracle and definitive Martingale. Regulation must evolve and control its action according to the situations, on a case-by-case basis. When the context is uncertain, precautionary margins should be more important. Today, however, official regulations are still far from this crucial flexibility.

If the supervision is removed, will the financial system be capable of regulating itself?

It takes common sense rules but we must be cautious of the false security brought by normative obsession. The challenge is to manage the bubbles without stifling growth. How can a global company with assets and liabilities in all developed/emergent countries organize its worldwide accounting? At one time, at AXA, we had three different accounting methods: European, American, and even Australian. And according to the method we used, we would obtain completely different results, sometimes even conflicting. In 1995, the U.S. accounting method would show a substantial loss while according to the European method we had comfortable profits. The following year, it was the opposite. Where was the truth of my group? In the United States, we lost money because our operations were assessed according to the market value of the moment, which suffered from a decline in prices that subsequently resulted in a depreciation of my assets. This loss was purely theoretical, since we were not selling anything. Just like the “benefits” of 1996.

After each crisis, regulators tend to impose new standards that converge to create the next crisis. Can we now, in 2013, imagine what will be the next crisis?
The subprime crisis, which was basically a result of President Clinton’s decision in the 90s to allow every American to buy a house, erupted a decade later when the real estate market, backed by toxic financial products, collapsed. Subsequently, there were huge sums of money which could no longer be invested in banned products and interest rates were reduced to very low levels by financial authorities to promote recovery. These are ideal conditions for irresponsibility to bloom. The actors face no monetary risk, so they will search elsewhere for this risk and its correlated yield. As a result, since 2008, housing bubbles have appeared here and there – bubbles that will eventually burst, sooner or later. As money moves without constraint, when an attempt to stem a crisis in one country is made, it creates the conditions for the burst of a crisis in another. This is the paradox of regulation.

Therefore, if it is impossible to avoid crises, should we just manage them?

The dream of all economists is to find the tool to bypass all crises. But this is foolish. The only reasonable approach is to anticipate a crisis, when the first signs start to show; and immediately change the rules to deflate the rising bubble, instead of believing that we can prevent the bubble from forming. But the truth is that most crises are inevitable.

Regarding financial regulation, is Europe a special case?

For banks, the new prudential standards have already disrupted the way we finance the economy in continental Europe. It should be recalled that it is not the same in Europe and in the Anglo-Saxon countries. The Eurozone is caracterized by the “originate to hold” model, in which finance is generally intermediated in the balance sheets of banks. In the United States, the dominant model, “originate to distribute” is based on the massive securitization of loans by the banks that initiate them.

What effect does this difference have on competition?

The U.S. banks have in their balance only 40% of their loans to households and businesses against 85% in the eurozone. The application of liquidity ratios is much more constraining for European banks and it could lead them to significantly reduce their credit activity. It may look like a paradox, but the new regulatory framework will promote the adoption of the “originate to distribute” model in Europe!

Regarding Solvency II and insurances, it should be noted that this is a strictly European regulation, which will not apply anywhere else.

The timing of the solvency ratios of Basel III, which included a staggered implementation until 2019, was shortened by six years. The European insurance companies also anticipated the ratios of Solvency II. This haste amplifies the effects of the reform in a context of economic stagnation. In the United States, the Fed has completely removed the liquidity ratios of Basel III and the implementation of Dodd-Frank Act is already significantly delayed, not to mention the many exemptions it contains.

Is responding to the crisis by taxation – as in France – the correct method?

France is in a particular situation, with a significant reinforcement of the taxation of savings, particularly risky and long-term savings – in other words, shareholdings. The taxation of dividends has also increased considerably (France is the OECD country with the highest taxes), and for capital gains it’s both too important (42% today) and too complex. If institutional investors withdrew as a result of prudential developments and if individual investors are discouraged from holding shares, who will be left to finance the economy? Who will be the long-term investors of our companies?

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