As the G20 April summit, which will discuss a reform of the global financial system, approaches, proposals and reports to guide such discussion are proliferating. When Richard Baldwin asked me to write an assessment of the de Larosiere report that came out last week, my first thought was that my colleague, Thomas Philippon, had just published a VoxEU summary of some such reports (including the NYU-Stern book Restoring Financial Stability: How To Repair a Failed System, the G30 report chaired by Paul Volcker, the Geneva report, proposals of Luigi Zingales, among others). What could I add more? Regardless, I sat to read the de Larosiere report and realised soon that a number of different economists and policymakers were reaching similar broad conclusions, even if the specific shades of each were nuanced. The near unanimity of opinion on what ought to be the future financial structure, even as there is perfect lack of unanimity on how to dissolve the ongoing crisis, struck me as peculiar. There must be one way to do things right and a million ways to botch them up! Nevertheless, the unanimity on the world order for future – at least on the financial front – seemed like the Cape of Good Hope. It may be hard to sort out the immediate mess, but as and when its hangover leaves us, we might have done enough groundwork to pave way for a robust, yet well-functioning financial system.
The de Larosiere report (“Report” going forward) covers a fair bit of ground. It is by design focused on the EU, but it does cover global aspects of the new reforms it proposes. It provides its take on the financial crisis but spends a fair bit of time on financial stability oversight and supervisory repair. This latter aspect of the report is its strongest part for several reasons. First, it is not as fully fleshed out in other reports; second, it talks about early warning systems, which need a certain amount of revamp, and, finally, it touches upon the difficult issue of how to organise supervision of different financial functions even as we set in place the so-called systemic risk regulator that will likely cut across all the functions.
Instead of going through the Report point-by-point and discussing pros and cons of each, I will focus on the issues I found most germane. In many cases, my assessment is to an extent based (biased!) on the collective thoughts of NYU-Stern faculty who contributed to our book. With that caveat and an offer that you contact me if you want any bold claims below to be substantiated with facts, let me move on…
Causes and regulatory repair
Overall, the Report focuses on the usual culprits: abundant liquidity (especially loose monetary policy in the US and the accumulation of large global imbalances elsewhere), failure of internal and external governance of financial institutions (risk management role and shareholder oversight, respectively), rating agencies’ modelling failures, ineffectiveness – and perhaps malfunctioning – of current capital requirements, and lack of any significant role played in global coordination by international agencies such as the IMF, Financial Stability Forum (FSF), G20, and others.
Most of the discussion here makes sense. Some things, however, stand out.
The Report discusses the “originate and distribute” model as having played a critical, detrimental role in the crisis and recommends that issuers of securitised products retain a meaningful amount of the underlying risk (non-hedged) on their books for the life of the instrument. In my opinion, the originate and distribute model’s role in this crisis has been overplayed and distracted attention away from the primary problem – that banks securitised without actually transferring sufficient risk.
Let me elaborate, as we have explained in the NYU-Stern book.
A large fraction of the mortgage originators in the US are now dead – why? Because they did have skin in the game, as economists would like them to have. Those who were supposed to take these risks and distribute them to rest of the financial sector – government-sponsored entities (GSEs) in the US and commercial and investment banks the world over – are, however, also close to being dead or “on oxygen”! This is because those who were supposed to – and believed to – be spreading risks around, instead took a large economic bet. They held the safest securitisation tranches, but did so for 53% (GSEs and banks put together) of all AAA mortgage-backed securities. The risk was low but the leverage sky-high. It was this phenomenon that converted the economic shock into a full-blown financial crisis.
To summarise, the real problem in the chain of linkages from origination of mortgages to their ultimate risk bearers occurred at the point of large banks and the GSEs. Once one focuses on what went wrong at this link and why, it is clear that some other aspects the Report focuses on – the perverse incentives of bankers given governance failures, the presence of under-priced (and in many cases, simply un-priced) government guarantees, the gaming of Basel capital requirements, and the opacity of securitisation structures and credit derivatives – appear to be the primary problems to go after.
A related point is marking-to-market, in whose absence funding would dry up for financial institutions much sooner than it has in its presence. Again, the real issue was incentives and not marking-to-market per se. Short-term incentives due to churning of traders across firms induced, and poor or silenced risk management enabled, those in charge of marking books to inflate prices and ride/create the asset “bubble”.
The Report does a pretty good job of proposing reasonable solutions to fix some of the real problems – multi-year setting of bonus standards, stronger roles for chief risk officers in company governance, pre-funding of deposit insurance funds (a missing feature in many countries in the EU), standardisation of derivative contracts with centralised clearing, and greater transparency requirement for the parallel/shadow banking sectors. These strike a chord with many of the other reports around.
Thus, on balance, the Report scores well, but it is not exactly regulation-light! It perhaps errs on the side of recommending too many interventions. It is quite likely that fixing a few root causes might be more desirable than going after every single symptom. The Report simply needs to prioritise its comprehensive list of policy reforms to achieve this.
One notable omission is any direct discussion of the too-big-to-fail problem and how regulators should quantify and/or penalise the systemic costs imposed by the growth and risk-taking at large, complex financial institutions. Another notable omission is a more detailed discussion of the problem that overall capitalisation of EU banks was poorer than that of the US banks (though the US banks took bigger risks), primarily due to lower insistence on prudent Tier 1 ratios in the EU. Indeed, marking-to-market also appears to have been more done conservatively by US banks (at least during the crisis), implying that EU banks may have more skeletons in their chest to take out in case the economic malaise persists. Some of these issues deserve greater investigation and discussion in a future version of the Report.
Supervisory and global repair
This aspect of the Report is truly first rate – conceptually clear and with sufficient implementation details (see Annex of the Brief Summary of the Report).
The overall approach is three-tiered:
- A systemic risk regulator at the “top” – the European Systemic Risk Council, which the Report recommends be housed at the European Central Bank.
- Functional regulators in the “middle” – European banking authority, European insurance authority, and European securities authority, for the respective functions.
- National versions of the three functional regulators at the “bottom”.
The functional regulators in the middle and the bottom would deal with each other; national regulators would coordinate their day-to-day supervisions; European functional regulators would coordinate overall supervision, macro-prudential supervision, and crisis-resolution activities; and finally, the European Systemic Risk Council would decide on the overall macro-prudential policy, employing risk warnings as inputs to EU supervisors (the “middle”) and giving them adequate direction based on comparisons across member countries.
Overall, this structure is attractive. It makes it clear that the key is to coordinate, not to centralise all activities in one institution. It also makes a definitive bid to set up an overarching regulator that can take a systemic perspective and cut across the various functional regulators and institutions. It recommends setting up global “colleges” of supervisors for cross-border institutions. Coincidentally, the scheme is rather similar to the one proposed in the NYU-Stern book, which recommends that every nation adopt a systemic risk regulator for its large, complex financial institutions and this regulator work with all the functional regulators and supervisors for banking, insurance, securities, and exchanges (who will do this last task is somewhat unclear in the plan of the de Larosiere Report).
The Report presents a timeframe of 2009-2012 to achieve this overall apparatus.
The systemic risk regulator, the European Systemic Risk Council, is also supposed to play an important global role. It is meant to harmonise several national regulations, importantly the Deposit Guarantee Schemes and their pre-funding, application of capital requirements, and quality of supervision standards. Any national exceptions are to be carefully assessed and approved. The Report sees the BIS, the FSF, and the IMF as all being relevant bodies to be informed about macro-prudential risks that relate to a global dysfunction of the monetary and financial systems.
The proposed model of a central bank-based systemic risk regulator aligning international regulation at a global forum seems the right one. But do we need the FSF, BIS, and IMF all there? This concerns me somewhat.
Perhaps the goal is to again coordinate rather than centralise, and that is what the Report might have in mind. For instance, it suggests that the FSF will be the primary coordinating body across nations, with BIS helping set international standards and the IMF helping out with early warning systems such as its Financial Sector Assessment Programme and also developing a global early warning system for financial stability based on “global risk map and credit register”. The Report also suggests an effective “tax” on non-abiding jurisdictions by requiring activities with their financial centres to be subject to higher capital requirements. On net, it favours a stronger role for the EU in the IMF and other multilateral fora.
Overall, there is little to complain about this part of the Report. It is well thought out and clearly laid out. One quibble, if I may, is the following. Though the Report does flag the issue of burden-sharing of the resolution costs for large bank failures, it would be good to get some more details on this rather important issue. My instinct is that we have yet to witness the big problems on this front. If some large banks or countries were to default, some clarity in thinking about burden-sharing among member EU states would help the authorities avoid losing valuable time in mid-crisis negotiations.
To summarise, the de Larosiere report represents an important contribution to providing a blueprint for the future global financial architecture. It takes several important steps forward, especially on its proposals for reform of the supervisory role in the EU regulation and to an extent also in the global coordination of reforms.
I wish to reiterate what I said at the start. There is an amazing consensus that is emerging on many things we need going forward to fix the global financial system. One hopes that the G20 summit won’t end up being the battlefield for countries and regions to win moral grounds on how to achieve this but instead a platform for genuine international alignment of key prudential reforms.
Well, let us wait and watch!