Some Principles for Re-Designing the Financial System

Posted by Sony Kapoor on 28 July 2009

Colossal taxpayer funded bailouts have steered us away from financial hell, at least for the time being. But the financial sector already wants to go back to ‘business as usual’. That way lies more fire and brimstone. Incorporating guiding principles in the design of regulations and bailout packages can help restore public confidence and ensure that we exit the crisis with a different but better financial system.

Competitiveness:

A 20%-25% return on equity for banks, 2/20 % hedge fund fee structures and more than $100 billion in bonus payouts are all signs of too little competition in the financial sector. When the sector reports 30%-40% of all corporate profits as it did in the US, it is evidence of an oligopoly which is parasitic to the real economy. We have a rentier financial system.

Current regulations favour big institutions over small, international banks over domestic banks and complex ones over simpler rivals. This asymmetry, economies of scale and the public subsidy that institutions considered ‘too big or too complex to fail’ enjoy has driven the trend towards ever greater consolidation into financial giants with few if any new entrants.

The high rewards available to employees and shareholders in a non-competitive system and the protection against failure for large institutions skew incentives and encourage speculative and destabilizing behaviour. Barriers to entry need to be lowered and financial institutions need to be broken up so their failure no longer poses a threat to the system.

This would not only deliver a much better deal for customers and investors but also for taxpayers since such a system would also be less likely to crash.

Diversity:

Soldiers crossing a bridge are asked to break step else the bridge would become unstable and collapse. Likewise financial stability comes from diversity of behaviour. When everyone wants to buy or sell at the same time we get asset price bubbles and collapses.

We need the whole range of financial institutions – savings banks, insurance firms, merchant banks, pension funds and development banks doing what they are supposed to do. When banks behave like hedge funds, hedge funds like banks and insurance companies like both we are in serious trouble.

Current regulation allows market prices and institutions’ own judgement of risk to influence how much capital they hold. Since this capital is held to guard against market and institutional failures in the first place, there is a big contradiction here. This, together with the use of similar risk management and bonus incentive systems drives everyone to invest in the same assets at the same time and reduces diversity. It has made the financial system more pro-cyclical, unstable and prone to systemic collapse.

Financial institutions need to be regulated by what they do not what they say they do. Capital requirements need to be mandated by regulators not markets or own judgement. Diversity can come from different investment horizons, incentive systems, risk appetites or regulatory requirements.

Simplicity:

Because financial regulation lacks broad principles, reactive efforts to ‘fine tune’ and adjust it have left us with tens of thousands of pages of laws and guidelines which are full of loopholes but act as a barrier to entry nonetheless. Moreover because these differ across jurisdictions and legal form financial institutions set up a complex network of hundreds of subsidiaries to game the system. This makes them not only too complex to fail but also in the case of behemoths such as Citicorp which has more than 2,000 subsidiaries (427 in tax havens) , too complex to manage.

What we need is to hardwire simple and blunt regulation such as caps on leverage, country by country reporting and prohibitions of off balance sheet exposures. This would be more effective if co-ordinated internationally.

There has been a parallel rise of the complexity of financial products driven by the fact that complexity increases profit margins and opportunities for regulatory arbitrage. It does so by increasing information asymmetry between the financial institutions on the one hand and its customers and regulators on the other.

Complexity in legal structures and products also increases opacity reduces supervisory effectiveness and thus increases systemic risk. Regulation needs to push for simplicity in legal structures and in financial products.

Fairness:

Large banks excel in reducing the tax burden on themselves, as well as on their employees and large customers through the use of complex products and legal structures often involving tax havens. In good times they do not pay their fair share of taxes and in bad times the little people like the rest of us who do pay our taxes bail them out. This is not only unfair but even more important destabilizing since it encourages excessive risk taking.

Polluters must be made to pay so there is an urgent need to crack down on tax avoidance by banks, bankers and their clients. While that can help reduce future abuse, the costs of ongoing and future bailouts must also be recovered from the financial sector through levying financial transaction taxes. These are easy to collect, hard to avoid, have a very progressive incidence, have the potential to increase stability and can be implemented unilaterally.

Compensation in the financial sector needs to be regulated sharply downwards to make it more symmetric. Current annual bonus structures drive short-termism, speculation and irresponsible behaviour because such behaviour can be highly rewarding. The only problem is that eventually the taxpayer has to foot the bill.

Sony Kapoor is the Managing Director of Re-Define (Re-thinking Development Finance & Environment www.re-define.org), an international Think Tank dedicated to improving the Development, Environment and Governance footprint of the financial system

Note: This piece is based on the Keynote Address delivered at the DGB Congress on the Future of Capitalism and a subsequent Op-ed in Suiddeutsche Zietung