The Future of Regulatory Reform

Bob Denham, 09 November 2010

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On 4 October 2010, CEPR held a major conference on financial regulation – The Future of Regulatory Reform – bringing together senior policymakers, leading academics and industry practitioners. Had this event taken place five years ago, the attendance would have been quite different. Those invited may well have accepted, but no doubt something would have come up. Client meetings, political briefings and PhD defences would have suddenly needed urgent attention. And the traffic would have been just awful. But this is 2010, and the room was packed. Even with London’s underground rail service blighted by strikes, one delegate walked for over an hour to arrive on time. As another attendee put it, regulation is now sexy.

Why the change in attitude? A simple answer would be that the world has just been through the most severe financial crisis since the Great Depression, and that the pain is not over. Yet this is perhaps too straightforward. As those attending agreed, the future will be anything but. The event’s co-organisers, CEPR President Richard Portes and Patricia Jackson, partner at Ernst & Young and board member at CEPR, argue that the timing is crucial. With the new regulatory landscape being decided by the end of this year, there is still active debate over several areas.

For many, this crisis should not be wasted. It offers a window of opportunity that has never been so wide open. José María Roldán of the Bank of Spain made the point that the regulatory body is by its nature static and the financial industry dynamic. For the first time though, says Jochen Sanio, President of the German financial regulator BaFin, the bank lobbyists are outside the room. ‘Now’, he argues, ‘is the hour of the regulator.’

Light years away

A central theme of the day was the need for ‘bank resolution’ – a code of conduct for the next time a systemically important financial institution (SIFI) becomes insolvent. According to Xavier Freixas of Pompeu Fabra University and CEPR, banks should no longer be able to hold the government hostage.

The crisis has been marked by unprecedented bailouts that have put government finances under severe strain. In Ireland for example, the latest bank bailouts in September amount to nearly one quarter of the country’s GDP. Financial regulation, Freixas argues, has failed to satisfy its core function of protecting society from the social cost of bankruptcies.

Many economists have criticised what they call a ‘moral hazard’ problem. Even in the face of financial difficulty, banks have had strong incentives to continue tossing the coin: if it lands on ‘heads’, the bank’s investments pay off; ‘tails’ and the government is forced to bail it out. Instead, argues Freixas, regulators should set up a ‘bank-specific’ bankruptcy code that adapts to the unique situation of each bank and removes the guarantee that banks will be bailed out, shifting the bargaining power from the bank’s shareholders to the government.

It is perhaps no surprise that delegates agreed that bank failure should no longer be allowed to bring down the financial system crippling the economy and holding governments to ransom. Yet the question remains, as Vicky Pryce, Managing Director at FTI Consulting, put it: ‘Are we really prepared to let banks fail?’. While this idea is becoming more

acceptable among US regulators, in Europe there remains substantial unease.
A priority among European policymakers is to shift the burden away from taxpayers. One suggestion put forward was ‘bail-ins’ where the creditors of banks themselves take a share of the cost without the need for the government to intervene. This appears to be a compromise born out of scepticism about an international framework. Jochen Sanio of BaFin argues that an international solution to bank failures – though desirable – is ‘light years away’, adding wryly that he is ‘an optimist with experience’ on these issues.

My country is my castle

While the financial crisis has made clear the risks of having banks that are too big to fail, awareness of the size and complexity of the problem is not new. As far back as 1997, economists speculated over the – then hypothetical – possibility of a cross-border bankruptcy, considering the case of Deutsche Bank.
According to data from 2008, Deutsche Bank is the second largest bank in the world with over $3 trillion in assets and 2,000 subsidiaries spread across more than 60 countries. Yet one-quarter of the bank’s assets are held in its London division, amounting to around one-third of the UK’s GDP. The question raised over a decade ago still has no answer: Who should step in if Deutsche Bank’s London operations have a liquidity problem? The Bank of England to cover the UK’s risk? The Bank of England on behalf of Germany? Or the Bundesbank?

Stijn Claessens of the IMF, Amsterdam University, and CEPR outlined the challenge facing regulators as what he and his co-authors call the ‘financial trilemma’. Policymakers have been trying to balance three objectives, he says, without accepting that only two of them are attainable.

The three objectives make up a triangle. At the top is the goal of global financial stability while on either corner along the base are the desire for keeping both cross-border banks and national authorities. The failure of a large cross-border bank poses national and international externalities, but national authorities – accountable primarily to their domestic taxpayers – largely ignore the international concerns. Over the last three years, only the bottom corners of the triangle have remained.

Financial trilemma

Stijn Claessens provides three solutions to this trilemma. On one extreme is territoriality whereby each nation ring-fences the bank’s activities under their domain. The second extreme is universalism. In this case, banks are regulated according to who owns them and in many cases the burden is shared between countries. A third approach lies between the two.

While territorialism has the advantage of providing governments with strong incentives to adequately supervise the banks within their jurisdiction, the incentives for considering spill-over effects on other countries are minimal. Claessens argues that this ‘my-country-is-my-castle’ attitude undermines the trend towards an open global financial system and may well lead to political disputes.

Universalism, on the other hand, supports the global trend, but not without causing its own conflicts of interest. Regulators would have to deal with delicate situations such as having a subsidiary that is systemic within the ‘host’ country but not in the ‘parent’ country. How to bargain fairly over the burden sharing in a way that avoids host governments simply relying on parent governments to carry the load – or the other way round – remains a sensitive issue. Jochen Sanio of BaFin argues that a universal system would require mediation from a universal authority stronger than any of the current global bodies.

One region where this may be possible, however, is the European Union where the legal and political framework is in place to enforce agreements. Claessens suggests beginning with a European Banking Charter that imposes sanctions on members who renege on their regulatory responsibilities. This could then be supported by a Europe-wide fund that would be able to step in during times of distress.
 

Yet the key problem, as raised by Claessens as well as others, is that any agreement is only as strong as the governing body overseeing it, which may well be too slow to react in times of crisis. Like many of the regulators and industry practitioners attending, Claessens views the universal system as something for the future rather than a realistic solution in the short term. He does however provide a proposal to overcome some of the barriers restricting today’s negotiations.

Examples of cross-border bank failures

Case Systemic in home country Systemic abroad Coordination Short-tem impact on financial stability
Lehman Brothers (USA and UK) Yes Yes No. Substantial instability.
AIG (USA) Yes Yes Unilateral bailout of units in 130+ countries by US government. May have prevented further deterioration in financial markets.
Fortis (Belgium, Luxembourg, Netherlands) Yes Yes Partly, improvised cooperation, "make do" solution. Bailout on basis of national entities, not for the Group as a whole. Enhanced stability in Belgian and Dutch banking system, but raised questions about how other cross-borded SIFIs might be handled.
Dexia (Belgium, France, Luxembourg) Yes No Yes, joint solution based on proportions of shares held by governments and institutional investors in 3 countries. Enhanced stability
Icelandic banks (Iceland) Yes No No. Iceland protected only by Icelandic depositors. Instability largely limited to Iceland (some unrest with retail depositors in other countries).
Central & Eastern European banking systems Mixed Yes Yes, joint solution based on European Bank Coordination ("Vienna") Initiative. Enhanced stability in Eastern & Western Eruope.

 

The third solution, an intermediate approach, builds on the already existing links and agreements between countries. Many countries currently share rules over supervision through agreements such as those put forward by the Basel Committee on Banking Supervision – the international forum for banking regulation.

Up to now, these bodies have neglected how to deal with bankruptcies, limiting their effectiveness during crises. Claessens emphasises the need to focus on the incentives for countries to cooperate, perhaps by formalising these in a treaty. Countries would need to agree on greater convergence in national rules, including those covering contingent capital, regulatory triggers for bankruptcy and how to deal with the bankruptcy when it does arrive. The closer the national rules are, the fewer conflicts of interest will arise.

The conference was noted for its frankness and honesty however, and not everyone shared Claessens’ optimism. Many argue that, of the solutions proposed, territorialism is still the most likely to be used. Jochen Sanio, reflecting on his experience at BaFin during the collapse of Lehman Brothers in 2008, added that, ‘countries were all on their own, and they will continue to be.’ But Claessens is clear in his warning that a territorial approach leads to a race to the bottom – with regulation becoming ever less effective. This debate continued to pepper the day’s discussions.

Wall Street reform

In his keynote speech, José María Roldán, Director General of Banking Regulation at the Bank of Spain, began with a stark reminder that the challenge goes deeper than legal and economic agreements between countries. ‘We cannot ignore that the regulatory process is politically driven’ he stresses. This is not a cry of despair however: while politicians bring added pressure for regulators, they also provide support for reforms that otherwise would not have been considered.

The political focus on regulation is met with ambivalence by many. Carol Sergeant, Chief Risk Officer at Lloyds Banking Group having previously held senior positions at the UK Financial Services Authority and the Bank of England, believes that the importance of regulation for the economy and thereby the lives of every citizen demands some political accountability. The problem for her and many others is that the quality of political debate can undermine regulators’ efforts. Political pressure also forces regulators to rush through reforms, running the risk that they are not as robust as hoped.

One measure that has gained public attention is the US Dodd-Frank Wall Street Reform and Consumer Protection Act – often referred to as Dodd-Frank after the main designers. Signed into law by President Barack Obama on 21 July 2010, it represents the most sweeping set of reforms of the US banking system since the Great Depression.
Of these, the Volcker Rule – named after former Fed Chairman Paul Volcker – is perhaps the most well-known. It advocates that ‘no bank or financial institution that contains a bank will own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit’.

A panel of discussants pointed out that there is no similar agreement in Europe, in part because policymakers – as well as many of the conference participants – remain unconvinced that such a policy would reduce risky behaviour and would actually work in practice. One attendee suggests that US banks will claim that every investment, including proprietary trading, is directly related to ‘serving customers’.

Despite being over two thousand pages, the Dodd-Frank act is still national legislation. While US policymakers are pushing for more international agreements, many conference attendees remain sceptical about an apparently international reform being driven by one country. ‘If there is to be international cooperation’, said one regulator present, ‘it needs to be on an open and equal basis, including all members of the Basel Committee’.

Another section of the act is designed to deal with regulatory capture – when state regulators are coerced into acting in the interest of commercial interests. This idea is more than just theory, argues Peter Praet of the National Bank of Belgium. He and others shared stories of how banks not only exploited their upper hand of having more information over the last decade, in some cases they used their influence to promote the careers of regulators they viewed as more lenient. In the trade-off between rules and discretion in financial regulation, Praet’s experience has led him to lean in favour of rules that cannot be interfered with.

Chasing shadows

A further concern to arise from Dodd-Frank act, as well as other national reforms, is whether it will lead to regulatory arbitrage – banks moving to areas where the regulation is lighter and thereby benefitting from the ‘race to the bottom’. Yet panellists were quick to dismiss this becoming a serious issue for most large banks, particularly those in the US, arguing that they will not suffer sufficiently to warrant moving and that the costs of doing so remain high.

José María Roldán maintains that we should ‘not fool ourselves’ though, and that regulatory arbitrage will occur to at least some extent. A less noticed form of arbitrage is between industries, for example some banking services can be provided by insurance companies. Roldán notes that one of the largest bailouts during the crisis was that of the US insurance giant AIG and that Dodd-Frank, for all its measures, only creates one new office for dealing with insurance companies.

This echoed another concern from the panel. If certain financial services are stopped from going through banks, they may well go elsewhere – an infamous destination being the shadow banking sector. Tobias Adrian of the Federal Reserve Bank of New York presented a co-authored paper – expressing his personal views – shedding light on the topic.

The shadow banking system is a collective name for financial intermediaries who, like traditional banks, are involved in the creation of credit within the global financial system, but unlike traditional banks do not accept deposits from the public and are not subject to regulatory oversight. This means they are not required to hold the same amount of capital as back up and, in the case that they are short of funding, they do not have access to the governments lending of last resort.

It was the run on these institutions, as the market lost faith in their model of investing in mortgage-backed assets, that triggered the turmoil in financial markets starting with subprime crisis of 2007 and eventually leading to the collapse of Lehman Brothers a year later. The sector’s interconnectedness with the traditional banking system was severely underestimated by credit rating agencies, regulators, governments and banks. Adrian points out that the situation was only stabilised after the US government effectively provided liquidity facilities and credit guarantees for the shadow banks as if they were traditional banks.

Yet despite its role in the crisis, Adrian argues that ‘shadow banking system’ is too shady a name for a sector that, while having many members who are out to avoid regulation, also has parts that provide innovation and specialisation necessary for any developed financial system to thrive. Adrian adds that the shadow banking system, which includes public as well as private participants, deals with roughly the same volume of credit as the traditional banking system – perhaps more.

Given the significant size of the shadow banking system and its inherent fragility, Adrian urges policymakers to assess whether shadow banks should have access to official backstops permanently or be ‘regulated out of existence’. Adrian prefers a nuanced approach whereby banks are regulated according to the function they perform in practice rather than by their institutional charter. Regulation by function could have ‘caught’ some of the harmful behaviour by shadow banks earlier, according to Adrian.

Selected conclusions on shadow banks from Shadow Banking, by Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, and Hayley Boesky, Federal Reserve Bank of New York Staff Reports, No. 458 July 2010

(1) The volume of credit intermediated by the shadow banking system is of comparable magnitude to credit intermediated by the traditional banking system
(2) Some segments of the shadow banking system have emerged through various channels of regulatory arbitrage with limited economic value.
(3) But equally large segments of the shadow banking system have been driven by gains from specialisation. It is more appropriate to refer to these segments as the ‘parallel’ banking system.
(4) Private sector balance sheets will always fail at internalising systemic risk. The official sector will always have to step in to help.
(7) Shadow banks will always exist. Their omnipresence – through arbitrage, innovation and gains from specialisation – is a standard feature of all advanced financial systems.
(8) Regulation by function is a more potent style of regulation than regulation by institutional charter. Regulation by function could have ‘caught’ shadow banks earlier.
 

Blaming the accountants

Blame for the crisis has also been aimed at accounting practises for masking the real risks from investors, in particular ‘fair value accounting’. This allows companies to value their assets according to the price that would be received in an ‘orderly’ market transaction during normal times. Some argue that this leads to inflated asset valuations during booms, allowing firms to take on excessive leverage based on assets that are over-valued, thereby adding to instability. During a downturn, companies then have to write-down the losses on their assets, leading to fire sales, further declines in asset prices, and so on in a downward spiral. Due to the interconnected nature of global finance, the effects can be widespread.

Yet the problems with fair value accounting are often taken for granted, according to Christian Laux of Vienna University of Economics and Business. In his presentation, he and his co-author find no evidence that fair value accounting actually contributed to the crisis in a major way. While admittedly there are costs associated with fair value accounting, Laux argues that every accounting rule has its own trade-off and will be appropriate for some assets and not others. He finds that the alternative method for valuing assets based on historical prices, historical cost accounting, would have fared no better. Patricia Jackson of Ernst and Young adds that, by and large, the assets that were marked down during the crisis had not been marked up in the first place.

Putting the brakes on the business cycle

Later in the afternoon, the discussion focused more directly on the latest reforms from the Basel Committee on Banking Supervision, known as Basel III after the Basel I and II reforms in 1988 and 2004, respectively.

A widespread concern about the Basel II rules is that they may have been exacerbating business cycle fluctuations. This tendency, known as procyclicality, means that during a downturn, capital requirements force banks to hold too much capital in reserve unnecessarily restricting their lending and thus deepening the recession. Yet when the economy recovers, the need for capital reserves reduces and provides incentives for banks to fuel credit booms.

In November 2008, just two months after the collapse of Lehman Brothers, the G20 countries met in Washington and outlined the need to correct this procyclical lending bias. This call has since been echoed by governments, central bankers and regulators around the world. In September this year the Basel Committee revealed the Basel III reforms which will be presented to the G20 in Seoul in November with a view to being implemented by 2013.

Procyclicality, Thomas Huertas (FSA)

Basel III’s stated aims are to improve the banking sector's ability to absorb shocks, to improve risk management, and to strengthen banks' transparency. To achieve this it sets out two areas of regulation: microprudential – dealing with the resilience of individual banks – and macroprudential – dealing with the health of the banking sector as a whole. To make the change from procyclical lending to countercyclical lending, Basel III reforms include increasing capital requirements and adding more capital buffers to deal with times of stress, rising from 2.5% to 7%.

Although there was broad consensus at the conference that these reforms are a step in the right direction, Rafael Repullo of CEMFI and CEPR, was quick to warn that ‘the devil is in the detail’. Repullo argues specifically against one of the recommendations: the creation of additional capital buffers, calling it ‘a bad policy that should be abandoned’. Using data from Spanish firms over two decades from 1987 to 2008, Repullo suggests that the best solution is to change the capital requirements according to the economy’s position along the business cycle – known as point-in-time capital requirements. Repullo argues this approach is simpler, more transparent, lower cost, and more consistent with how banks currently manage their risk.

Commenting on Repullo’s findings, Thomas Huertas of the UK Financial Services Authority (FSA) reminded delegates that in order to ensure that the banking sector is not procyclical, regulators must be clear on what they mean by ‘cyclical’. If during an upturn in the cycle, banks provide too much credit which causes yet more growth, it may be unclear that this is indeed an unsustainable bubble and that banks should therefore be increasing their capital buffers rather than lowering them. Huertas wonders whether controls on borrowers, such as a cap on loan size compared to the security, might be a more effective way of controlling total credit.

A tax on the banks

Earlier in the day, Javier Suarez of CEMFI and CEPR had also been critical of a part of Basel III: the liquidity coverage ratio, a move designed to secure short-term cash flows. Instead Suarez proposes a direct tax on the short-term funding of banks.

Short-term funding is attractive to banks because it can facilitate the rapid expansion of credit and growth of the business. The downside is that this can also lead to over reliance on short-term funding leaving a bank exposed when the need to refinance arises and leaving society open to the social cost of contagion in the financial system.

Suarez proposes using a Pigouvian tax, named after the Cambridge economist Pigou who first suggested such a tax in 1954, that would be levied on banks with large amounts short-term funding to compensate society for the systemic risks. Suarez argues that this is an improvement over the set liquidity-coverage ratio, as banks with a greater ability to assess credit risk and make innovative investments could do so and pay the tax to cover the extra risk. Given that some banks will still want to take excessive gambles however, Suarez prefers a combination of the two measures.

In discussing the paper, Oliver Burkat of the Committee of European Securities Regulators, welcomed the innovative use of a Pigou tax which is traditionally used in dealing with environmental issues. However his concern, a recurring message from the day, is how to verify what is meant by systemic risk and whether regulators can enforce rules based on this measure.

Be careful what you wish for

Throughout the day, delegates reflected on general lessons from the crisis. Should regulators have foreseen the crisis better? Peter Praet of the National Bank of Belgium outlines his main lesson from the crisis as needing to ‘think the unthinkable’. Regulators should have a clear plan for every eventuality, he says, likening a financial crisis to a war situation, with even the most experienced professionals rendered useless if they do not know what is expected of them. More than just agreements on bank resolution, regulators need an action plan.

Carol Sargeant, of Lloyds Banking Group, is more critical. Rather than being unthinkable, the crisis was a ‘coincidence of thinkable events’. Regulators’ inability to prepare for the crisis reflects what Sargeant regards as a societal illusion that we could live without risk, epitomised in the words of former British Prime Minister Gordon Brown: ‘No more boom and bust’. People cannot get rid of risk, argues Sargeant, they can only replace risk – hopefully with risk they can manage, but sometimes with risk they underestimate.
Nevertheless, Carol Sargeant is clear that regulators are in an unenviable situation. The challenge facing regulators was repeated regularly during the day. On one side is the pressure from an eager political mood for change and an expectant public, while on the other is the complexity of regulating an inherently changing industry.

Many regulators express uncertainty over what will happen. Carol Sargeant pictures regulatory changes as pulling a big lever that will affect the system in numerous ways – as highlighted throughout the day – that are impossible to fully predict. To this she adds the warning that the private sector will adapt to any regulation, and cautions that regulators should be careful what they wish for. Solving yesterday’s problems may leave weaknesses for tomorrow’s – or worse, create whole new ones.

Looking forward

In his closing remarks, Xavier Freixas remained optimistic about the changes already being made but fears for their longevity. If as is hoped, a systemic crisis takes place only rarely, then memories of the current crisis can begin to fade. Support for the new rules can slowly wear, leaving regulators exposed. Future financiers may argue for cut backs to the reforms, claiming that ‘this time is different’ – the title of the famous book by Carmen Reinhart and Kenneth Rogof. The crisis, and the debate over regulation to protect against it, can become all too easy to forget.

Xavier Freixas will be organising CEPR’s next conference on regulation, building on many of the issues raised. By holding such events, CEPR hopes that forgetfulness is one vice that can be regulated.

CEPR will be holding several events on this topic and others later this year and early in 2011, see the CEPR events diary for more details.

Delegates quoted were speaking in their personal capacity and their views do not necessarily reflect those of the organisations to which they are affiliated.

 

URL:  http://dev3.cepr.org/meets/ltm/2432/prog.pdf

Topics:  Global governance

Tags:  regulatory reform

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