What international experience tells us about financial stability regulatory reforms

Posted by on 21 December 2009

The global financial crisis has revealed the “fallacy of composition” in the supervision of the financial system. While financial supervisors deemed each individual institution to be sound, risks were building in the system. Individual countries and the Financial Stability Board seek to develop a regulatory approach to stability at national and global level respectively. Here, I offer criteria for effective regulation of financial stability and review the proposed reforms in the European Union and the US.

Criteria for effective regulation:

A multidisciplinary, multi-agency function is essential. And the regulator needs accountability, binding powers and effective implementation.

Financial stability regulation maintains the stable provision of financial services to the wider economy. Numerous risks lie outside the oversight of the banking supervisor. Therefore, the views of central banks and banking supervisors need to be complemented by those of regulators in securities and insurance; ministries of finance and debt managers.

Furthermore, central banks may face conflicts related to financial stability. For example, the independence of central banks in maintaining price stability could be compromised if they were to play a dominant role in macro-prudential regulation and supervision.

Second, both central banks and fiscal authorities need to be involved in three key competencies related to financial stability: liquidity provision; prescriptions and proscriptions for the behaviour of financial actors; and solvency support.

Third, a conflict exists between banking supervision and macro-prudential supervision: in good times, it is impossible for regulators to be “tough”, for the same reason that it is impossible for politicians to resist short-term determinism in spending decisions. Any regulatory construct needs to involve a multitude of stakeholders in financial stability.

To be effective, the stability regulator must be independent of political considerations and separate from the micro-supervision of individual banks. For a disinterested assessment, the regulator can have nothing other than its own reputation riding on the assessment and cannot be involved in day-to-day supervision. Also, it must be independent of the political system and the interests of other institutions.

Accountability requires clear regulatory objectives, a clear mandate, and clear processes for preventing, managing, and resolving crises. It cannot be limited to reporting obligations. Sanctions, punishment, or both should be imposed on the systemic regulator if it performs inadequately. Ideally, it is desirable to create incentives such as deferred compensation and to require the periodic publication of stability reports with which to compare actual performance with the warnings of the regulator.

The regulator should not be conceived simply as a “reputational” body composed of high-level members who influence by their moral authority alone. It needs binding powers and the ability to impose measures on other regulators and financial institutions.

Finally, adequate internal capacity and sufficient resources are needed. The decision-making process requires multidimensional, independent talent, knowledge, and expertise.

Financial stability reform in the EU and the US. How do the recent reforms proposed in the EU and the US fare against these criteria? The EU has a fairly definitive plan. The US has two proposals before Congress: the one presented in this paper and one submitted by Senator Dodd, with no support from the White House.

In September 2009, the Commission of the European Communities proposed the creation of several EU-level agencies to supervise systemically important cross-border banks, other financial institutions, markets, and instruments. These include the European Systemic Risk Board , a steering committee, and a technical advisory committee. This approach has glaring limitations:

- It does not take a multidisciplinary, multiagency approach to systemic risk. Central banks are heavily over-represented, and there is no clear distinction between the European Central Bank and the ESRB. Given the dominance of central bankers, the ECB dominates the other views and expertise on the ESRB in the decision-making process.

- The process is unwieldy (more than 61 members), which is why the steering committee was established. The ECB dominates the process with analytical support and voting rights.

- The ESRB is a “reputational” body, virtually replicating the ECB. Its recommendations are not legally binding, although the recipients of recommendations must respond once a risk has been identified. It does not have clear objectives, mandate, accountability, or processes.

- As with the ECB, accountability entails reporting obligations, but no sanctions or punishment for inadequate performance.

- The central banks in control of the ESRB might be conflicted in their use of the available instruments, especially in the setting of short-term interest rates.

- The cross-border framework for managing and resolving crises is weak. The conflicting proceedings and competencies impede information sharing and collaboration.

Last month, the US House Financial Services Committee released a bill that aimed to minimize the threats from firms that posed a “systemic risk” to the overall economy. The bill creates a Financial Services Oversight Council, chaired by the Treasury secretary and including the chairman of the Federal Reserve and the heads of six regulatory agencies. The council is remarkably similar to the President’s Working Group on Financial Markets. The proposed approach does not streamline the US system of financial regulation. In particular;

- The Treasury secretary chairs the council, which is not independent of or immune to political considerations.

- The council brings all regulators to the table, but does not cover some sources of systemic risks, such as consumer debt overhang.

- It lacks authority to take binding decisions and an explicit process for authorizing the use of fiscal resources subject to congressional scrutiny.

- It can develop “heightened prudential standards” for individual institutions, but not address systemic risks.

To conclude, both the EU and US are proposing regulatory reforms in response to the crisis, but the proposals have drawbacks. Any serious proposal to establish a regulatory framework has to find satisfactory solutions in four areas: regulatory objectives, regulatory structure, regulatory resources, and regulatory implementation.

The EU and US are encouraged not to rush the reform but proceed in a thoughtful, deliberate fashion that meets the criteria offered in this article.