New financial regulations may be helping to restore investor confidence but, according to the CEO of Dexia Asset Management, they are also in danger of shaping a new investment landscape that could cause further damage to the global economy in the long term.
Rebuilding investor trust in the efficiency and integrity of financial markets is essential to encourage long-term savings and financial investments, and to restore sustainable economic growth. In so far as regulations bolster investor confidence and enhance the stability of the financial system, they allow the financial industry to better fulfil its intermediary role in the creation of long-term wealth.
So how effective is the raft of new regulations in restoring trust and in promoting investment?
The major regulatory reforms impacting insurers, banks and pension funds in the wake of the financial crisis have forcefully demonstrated the need for more adequate capital requirements and consistent, ‘hands-on’ supervision. A single European rulebook is being developed in order to achieve better alignment of regulatory approaches across the different European financial sectors.
Knee-jerk reaction
In asset management, there are also many examples of regulations designed to enhance investor confidence in investment products and services. For instance, the well-established Undertakings for Collective Investment in Transferable Securities III and IV directives ensure increased transparency of investment products and promote cross-border mobility in Europe (the latter, however, is subject to further fiscal harmonisation). Harmonisation and enhanced investor protection are also integral to initiatives such as Markets in Financial Instruments Directive II and Alternative Investment Fund Managers Directive.
The Packaged Retail Investment Products (PRIPs) initiative is a good case in point of regulation aimed at restoring retail investors’ trust, as it harmonises sales and disclosure rules and increases product comparability. PRIPs is also a very important first step towards establishing a level playing field in Europe for different investment products and providers.
But as regulatory reform goes, important caveats remain. One worrying tendency among regulators is to add complexity that does not result in a concomitant positive final effect for investors.
In a recent paper by the Bank of England – 'The Dog and the Frisbee' – Andrew Haldane and Vasileios Madouros challenged the effectiveness of overly complex regulation as, according to their research, it reduces the robustness of models and regulations. They also raised the question of costs, noting that “collecting and processing the information necessary for complex decision-making is costly, perhaps punitively so”.
As an asset manager, at Dexia Asset Management we can only agree. Furthermore, while a solid and straight-forward regulatory framework strengthens trust in the European market place, exceedingly complex and costly rules do not bode well for the relative competitiveness of Europe vis à vis financial centres in other parts of the world.
Short-term solutions
Perhaps our biggest concern regarding the effectiveness and the timing of new regulation, however, is the bias against long-term investing in the real economy that is implied by some of the new capital and liquidity rules. Under Solvency II, for instance, the new capital charges practically deter insurers from investing in global equities, private equity and infrastructure. Similarly, Basel III forces the banking system to take less risk, precisely at a time when the state of the economy requires the opposite.
By the same token, the use of 'mark-to-market' accounting rules increases the volatility of balance sheets, making the financial system more pro-cyclical instead of promoting long-term stability. Plans to extend Solvency II capital requirements to pension funds could seriously hamper their capacity to invest in risky assets (for example, equities) at a time when such long-term investments in the real economy are particularly needed.
As a final, global example, by calling for more transparency and disclosure by sovereign wealth funds (SWFs), the Santiago Principles have had the unintended consequence of shortening the time horizon of SWFs, thereby pushing these supposedly long-term investors to prioritise short-term performance.
It seems that regulations are moving into dangerous territory when long-term risk-taking is punished. Indeed, only long-term, risk-bearing investment in the productive potential of an economy can guarantee that enough growth and income are generated for governments to repay their debts and for insurers and pension funds to honour their liabilities.
While lax regulation is a proven recipe for disaster, badly timed and overly complex regulation may well be counter-productive. It might even limit the ability of the financial system to take on the level of risk to finance the productive investments necessary to build our long-term wealth.
Recent regulatory efforts have been working hard at harmonising supervision, enhancing transparency, and increasing investor protection. But a sharper focus on promoting and supporting long-term investing will be crucial to sustainably restore growth.
Naïm Abou-Jaoudé is CEO of Dexia Asset Management.
