There are a whole load of things we are grappling with today, and not many people seem to know how to grapple with them well. There is a challenge, for example, regarding definitions.
Defining what is systemically important versus what is not. Defining what is commercial trade versus speculative. Defining appropriate levels of capital versus required levels of capital. Defining what trust means and more.
What is systemically important?
Global regulators are claiming a need to protect systemically important financial institutions (SIFIs), as these are the ones they view as too big to fail. So, a SIFI is an institution that a country defines as being capable of bringing down the country. This means that BNP Paribas is systemically important to France, as it controls about 40% of all transactions that take place in the country. By the same token, Lloyds-HBOS and RBS are systemically important to the UK, as Citi, Bank of America Merrill Lynch and JPMorgan Chase are to the US. AIB and Bank of Ireland are systemically important to Ireland in the same way as Icesave is to Iceland.
What is systemically unimportant?
However, things get trickier when you ask what is systemically unimportant. Where do Northern Rock, Bear Stearns or Lehman Brothers fit in?
The truth is, every SIFI is linked to a lesser SIFI which, in turn, is linked to a smaller SIFI, and so the discussion of what is systemically important is purely a matter of scale and economy.
What this really means is that for the most globally interconnected SIFIs, we need living wills - a method of letting such an institution fail in a matter of days, without bringing down the whole financial system.
I would like to see living wills for every bank, taking the view that systemically important is purely relative. However, for the truly cross-border banks that are systemically important, rather than national banks, this should extend further to an unravelling plan that can be achieved without disrupting interconnected counterparties.
That's darned difficult, but will be something the regulators will have to tackle - in fact some already are.
OTC derivatives
Regulators are also looking at over-the-counter (OTC) derivatives - saying that those related to commercial activity are fine, but those used for purely speculative purposes are not.
That is another tough call.
Is investing in an OTC derivative to hedge US dollars against Chinese remnimbi in a three-month forward swap commercially sensible? Yes, but it could just as easily be a speculative hedge. How do you decide?
Regulators say that it is down to whether the investment can (a) be shown to be related to a commercial reason and (b) whether it is systemically important, as in major investing versus minor.
Again, all difficult to determine.
Major versus minor, commercially justified versus unjustified, systemically important versus unimportant - is all very much guesswork.
These are all questions that regulators struggle with: levels of capital, liquidity risk, collateral and assets required, deposit to loan ratios, leverage ratios... you name it.
Reminiscent of MiFID discussions
In many ways, the issues are similar to those which surfaced during the original discussions about the Markets in Financial Instruments Directive (MiFID), when the European Commission said a systematic internaliser is a business that trades 15% of its business off its own book.
Questions asked then included: how they would measure that? Volume or value? Equities only or all instruments? Europe only, eurozone only or general book of business?
And, as most banks do not report these figures, how would they find out anyway?
All in all, no matter how much regulators want to enforce the rules, they will struggle until they can come up with some sensible definitions that they and the industry can implement.
Chris Skinner is an independent financial commentator and chairman of London-based The Financial Services club (www.thefinansier.com)
