Financial Regulation and Its Limits

Respinning the web
By John Plender
Published: June 21 2009 19:23 Financial Times

If the financial crisis has taught us anything,” says Michael Taylor, “it is that too much conventional wisdom can be dangerous.” So there is something “slightly unnerving”, adds the former International Monetary Fund economist, about the speed with which a new consensus has emerged on the re-regulation of the financial system – especially when it comes to the concept known in bankerly jargon as “macro-prudential” regulation.

In essence this boils down to the idea that regulation should focus much more on systemic risks instead of assuming that a sound system can be built simply by supervising individual banks. It aims to restrain the kind of build-up of systemic risk that occurred during the credit bubble and which is difficult to address by raising interest rates to damp down asset prices. The chief weapon in the macro-prudential armoury is a capital regime for banks that curbs excessive credit growth.

The effectiveness of macro-prudential regulation is a core assumption behind the capital proposals in last week’s US Treasury white paper on financial regulation. The concept was also roundly endorsed by the de Larosière report to the European Union and in the Turner review in the UK. The underlying philosophy is that if macro-economic analysis had been brought to bear on the design of the financial system, the current debacle might have been either pre-empted or rendered less devastating.

Heavy reliance, then, is being placed on the ability of this new regulatory approach to prevent a future global financial crisis. Yet there is no agreement on how it might work in practice and good reason to question whether it will live up to its advance billing. One very senior former member of the global central banking establishment even says “not only is macro-prudential regulation rubbish, but it gives rubbish a bad name”.

The starting point in the argument is that banking is different. First, because banks borrow short and lend long in the interests of the wider economy but at the cost of putting themselves in a fundamentally risky position: if depositors demand their money back simultaneously, banks cannot pay up because of the mismatch in the maturity of their assets and liabilities. Second, because a loss of confidence in one bank can become contagious across the system. Third, bank failures have externalities, or side effects, that not only inflict losses on other banks but also damage the wider economy – for example, by curbing the supply of credit.

An important role of bank regulation, as the US Treasury white paper underlines, is precisely to address such externalities. It proposes to compel the largest, most interconnected, highly leveraged institutions “to internalize the costs they could impose on society in the event of failure” by imposing tougher capital requirements.

In the run up to the financial crisis the regulatory approach was entirely micro-prudential: it assumed that, if bank supervisors ensured individual banks were safe, systemic stability would look after itself. Yet in a recent report – The Fundamental Principles of Financial Regulation – a group of prominent bankers and academics points out that this view “sounds like a truism, but in practice it represents a fallacy of composition”. This is because, in trying to make themselves safer in a crisis, banks can behave in a way that collectively undermines the system.

It may be prudent, for example, for an individual bank to sell assets when the price of risk increases. Yet if many banks do the same, the asset price will collapse, causing banks to take further steps that can lead to a vicious, self-reinforcing downward spiral in asset prices.

The Turner Review highlights the practical consequences of an unbalanced regulatory approach. In the build-up to the crisis, it says, the Bank of England tended to focus on monetary policy analysis, as required by its inflation target. While the review praises the Bank’s analytical work for its regular Financial Stability Review, it notes that the analysis did not result in policy responses to off-set the risks identified.

For its part, the Financial Services Authority, the UK’s principal regulator, focused too much on the supervision of individual institutions, and insufficiently on wider sectoral and system-wide risks. The review concludes that the vital activity of macro-prudential analysis fell between two stools, leading to what Paul Tucker, deputy governor of the Bank of England, has called “underlap”.

Systemic instability has been further compounded by the pro-cyclicality of regulation, whereby banks are not required to build up enough capital in the good times and are obliged to increase capital in the downturn, so accentuating boom and bust. Much of the damage wrought in the financial crisis was a direct result of Basel I, the global capital regime agreed by the world’s financial regulators. This treated all mortgages as equally risky, so that bankers could take on very high-risk, high-reward subprime mortgage business without having to back it with more capital than that required for safer mortgage business.

Basel II, which started to be implemented last year, addressed this problem by breaking assets down into subcategories and applying risk weights to them. Yet this actually increases pro-cyclicality: as risk grows in the recession, in contrast to Basel I, banks are required to hold more capital just when they are most under pressure. This pro-cyclicality is further exacerbated by mark-to-market accounting, which adds to asset values in the good times and inflicts additional shrinkage when markets turn down.

Bank regulators around the world are already working to reduce the pro-cyclical bias in the system by tinkering with capital adequacy requirements. Yet Lord Turner, chairman of the UK’s FSA, argues that there is a case for going further to introduce overt counter-cyclicality, whereby required and actual capital would rise in good years when loan losses are below long-run averages, creating capital buffers that would be drawn down in bad years as losses increased. He also argues for an overall leverage ratio, looking at assets in relation to capital, as a backstop control measure. Such a ratio also features in the financial regulation plans of the administration of US President Barack Obama.

Capital requirements that track the cycle, together with overall leverage ratios, are thus central planks of the macro-prudential approach. Yet the attempt to counter pro-cyclicality raises huge questions, most notably on the issue of whether regulators should have discretion to change capital requirements in the course of the cycle or whether the capital regime should be subject to pre-determined rules. In a perfect world, giving discretion to regulators to calibrate capital requirements according to the state of the economy makes sense. In the real world, regulators would face the ever-difficult problem of defining where they were in the economic cycle.

Sir Andrew Large, former deputy governor of the Bank of England for financial stability, says the problems of judging how close the system is to a tipping point can be overstated. “I argue that people could put levels of probability on their assessment and then act to calm things down.”

Yet few deny that regulators making such judgments would be subject to huge pressures because, by definition, the purpose is to prevent financial institutions doing what they want to do by making it more expensive or off limits. Charles Goodhart of the London School of Economics, and a former member of the Bank of England monetary policy committee, says regulators and supervisors “will be roundly condemned for tightening regulatory conditions in asset price booms by the combined forces of lenders, borrowers and politicians, the latter tending to regard cyclical bubbles as beneficent trend improvements due to their own improved policies”.

As with monetary policy, it is politically difficult for the guardians of the financial system to take measures that will reduce economic growth in the short term in the interests of fending off a recession no one thinks will happen while the good times still roll.

There lies the case for a rules-based approach. Yet designing a set of rules is no easy task (see box). It would also bring added complexity, not least because big multinational banks operating in different economies would be affected by many different cycles. And there is a risk that inflexible rules could lead to regulatory arbitrage.

Regulatory expert Michael Taylor compares counter-cyclical capital buffers with the “corset”, a form of quantitative control introduced in the UK in 1973 that penalised banks whose deposits grew faster than a pre-set limit. This simply drove money off-shore and the regime had to be scrapped in 1980.

Nor are rules a guarantee against lobbying pressure. The Bank of Spain has been much praised for introducing counter-cyclical provisioning that helped the Spanish banking system to weather the crisis better than most. Yet, as Mr Taylor points out, the Spanish central bank watered down its rules in 2004 because of lobbying by the industry, which argued that the length of the economic expansion had made such rules redundant.

These difficulties with macro-prudential regulation notwithstanding, the direction of travel is clear. Perhaps the most articulate advocate is the FSA’s Lord Turner, who argues in his review for the counter-cyclical regime to be substantially rules based. Yet he wants the best of both worlds, saying that this could be combined with regulatory discretion to add a further layer of requirements if macro-prudential analysis suggested this was appropriate.

The debate on rules versus discretion is set to run and run. There is a risk that more is expected of the macro-prudential approach than it is capable of delivering. This is because financial crises are often precipitated by unprecedented shocks that are inherently difficult to foresee. Yet Sir Andrew Large makes a parallel with the argument for independent central banking 30 or 40 years ago. Most people thought it was too difficult. But it happened, with what he regards as quite creditable results. “We need to have the self-confidence to do the same with systemic stability,” he adds, “for without such a policy we will be condemned to repeat today’s disaster in 10 or 20 years time.”

Fallout and factions: the drama of rewriting the rules

The next 12 months could bring the most dramatic change in financial services regulation in decades, as the US, the UK and the European Union try to tackle the causes of, and fallout from, the global downturn. Plans are moving forward to tighten the rules on everything from hedge funds and over-the-counter derivatives to mortgages and basic bank capital requirements, writes Brooke Masters.

In the US, President Barack Obama has unveiled detailed reform plans. He wants to consolidate several federal banking regulators and give the Federal Reserve new power to regulate systemic risk, supplemented with a council of regulators from other agencies. He also wants to create a consumer financial protection agency to regulate credit cards and mortgages, and require registration for hedge funds and central clearing for many derivatives. Parts of the scheme are already meeting scepticism from Congress, so it is not clear how much will become reality.

The EU is moving in a more piecemeal fashion. The European Commission has put forward an alternative investment directive that would force hedge funds and private equity firms to seek regulatory authorisation, report their strategies and set aside capital against losses. Regulators would also be able to set limits on borrowing. The proposal has drawn sharp criticism from London, where much of the European alternative investment management industry is based, for being restrictive and anticompetitive.

EU leaders are also considering plans to create a pan-European board to monitor systemic risk, as well as a college of supervisors that would provide more consistency among national bank supervisors and resolve disputes among countries. But Gordon Brown, UK prime minister, is fighting plans to make the president of the European Central Bank (to which the UK does not belong) chair of the systemic risk board. London has already secured guarantees that the new supervisory system cannot force any single country to commit taxpayer funds to bail out a troubled bank.

In the UK, the Treasury is due to bring forward its proposal for financial regulation shortly, but splits are opening up. Mervyn King, governor of the Bank of England, wants his institution to be in charge of systemic regulation and has asked for more power to do it. But the Labour government is largely defending the tripartite system it set up more than a decade ago, which divides power among the Bank, the Treasury and the Financial Services Authority.

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The beauty of the Spanish method

Creating a counter-cyclical capital regime for banks is tough but it has been done, most notably in Spain. Since 2000 banks there have had to make provisions for latent portfolio losses – those likely to occur but which are unrecognised by conventional accounting. This buffer takes the form of a reserve deducted from capital in good times and released in the downturn. It is calculated by comparing long-run credit growth in the economy with the current rate of credit growth. “Dynamic provisioning” offers a better idea of profitability and solvency over time and helps prevent dividend increases in good times that might undermine banks’ solvency. But the Spanish model is not compliant with global accounting standards. And it did not prevent a housing bubble as the macro-prudential approach battled a fierce monetary headwind – the European Central Bank’s one-size- fits-all interest rate was lower than appropriate for a boom economy. Spain’s banking system has nonetheless come through the crisis in better shape than most.