Over the last year, it has seemed as though not a single day passed without an internationally prominent figure – economist or politician – urging effective implementation and better coordination of the new financial regulations currently under construction around the globe.
The G20 finance ministers and central bank governors were a new addition to the choir who, at their 19-20 April 2012 meeting, reaffirmed their commitment to common global standards (FSB 2012). First established by the G7 in 1999, the Financial Stability Board was re-established by the G20 in 2009 to coordinate the work of national financial authorities and international standard setting bodies at the international level, and now functions as the regulatory arm of the G20.
As has been widely acknowledged, one of the several regulatory failures behind the global financial crisis that started in 2007 was the regulatory focus on individual rather than collective or systemic risk of financial institutions. Despite this, even the new international standards issued by the Financial Stability Board in its October 2011 "Key Attributes" document mostly focus on individual financial institutions (FSB 2011). Importantly, the main focus is not on all financial institutions as a collective group, but only on those financial institutions to be deemed systemically important. This will likely divert risks to the weakly regulated or unregulated parts of shadow banking.
Even ignoring the issue of regulatory arbitrage and shadow banking, the progress on the global implementation of new financial regulations has been slow. The main reason behind this is that many systemically important financial institutions operate across borders, but there are different styles and interests of regulators in different countries.
There is, however, a alternative and better design for global financial regulation: one that is likely to harmonise existing regulations and is reasonably immune to the risks posed by shadow banking evolution.
As we argued at the Federal Reserve conference in Washington in March 2012, regulators such as the Financial Stability Board should design the architecture of global finance around the safety and soundness of systemically important financial instruments (Acharya and Öncü 2012).
Examples of systemically important financial instruments include demand deposits, repos and over-the-counter derivatives on the liabilities side. Such liabilities, when faced with losses in case of counterparty’s default, would trigger runs on other entities. On the assets side, they are potentially illiquid, high risk assets financed through systemically important liabilities. Fire sales of such assets lead to a collapse in their value inflicting collateral damage on other holders of such assets. Examples include exposures to asset-backed securities backing asset-backed commercial paper and mortgage-backed securities backing repurchase agreements (‘repos’).
Why design regulation at the level of these assets and liabilities? The point is to regulate all institutions holding such assets, regardless of their home country or whether they are deemed systemically important by a regulator in another part of the world.
What would the regulation of such assets and liabilities entail?
It would require dedicated utilities, such as ‘clearinghouses’ for derivatives. These utilities, operating at the level of individual assets and liabilities (for example, a ‘repo’ clearinghouse), would deal with defaults by ensuring orderly liquidation of positions. And, recognising that such liquidation poses significant risks, there would be limits imposed on the risk of positions in the first place. This could be achieved through upfront margins, variation margins based on changes in market values, position limits, and in extreme cases, imposing circuit-breakers.
The Financial Stability Board can coordinate at the global level the setting up of such utilities and can harmonise and enforce their risk management standards. This would be far easier than designing regulations that operate at the level of individual institutional forms. If shadow banking develops newer assets and liabilities, then, as and when they mature (e.g. when the become commoditised or standardised), newer utilities would be introduced in the financial sector.
The Federal Reserve, the Bank of England and the ECB set up several facilities to halt a total financial collapse during the heydays of the ongoing global financial crisis. These have invariably been facilities set up for systemically-important financial instruments.
For instance, the Fed introduced the Term Auction Facility, which auctioned term loans to depository institutions, and the Primary Dealer Credit Facility, which provided overnight loans to primary dealers, to effectively lengthen the maturity of their systemically important liabilities. The Fed’s Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility and Term Asset-Backed Securities Loan Facility, which provided liquidity directly to borrowers holding systemically important assets.
Stated differently, financial regulators around the globe were forced in the midst of a crisis to act on systemically important assets and liabilities, rather than just on individual financial institutions holding them. The key is to recognise the need for such action ahead of time and build the essential infrastructure to ensure that excessive risk-taking is discouraged and markets know that regulators have an orderly resolution plan.
Acharya and Öncü (2012), “A Proposal for the Resolution of Systemically Important Assets and Liabilities: The Case of the Repo Market”, Federal Reserve Board’s research conference on "Central Banking: Before, During and After the Crisis" in honour of Don Kohn, 23-24 March.
Financial Stability Board (FSB) (2012), “Financial Stability Board reports to G20 on progress of financial regulatory reforms”, press release, 20 April.
Financial Stability Board (2011) “Key Attributes of Effective Resolution Regimes for Financial Institutions”, October.