Regulatory bodies must not go too far chasing the wrong priorities

The world has seen the emergence of a regulatory and market upheaval on an almost unprecedented scale, which has driven down markets, undermined public confidence in the financial system, generated public sector bailouts with an incalculable cost to the taxpayer and brought about the demise of household names in both the wholesale and retail sectors.

As to its cause, there has been an unsurprising degree of unanimity - weaknesses in regulatory coverage, failures in risk management and corporate governance, inadequacies in prudential regulation and failures in regulatory efficiency and communication at both the macro- and micro-level.

Perhaps not surprisingly, rather less publicity has been given to the role of governments in encouraging banks and other lending institutions to issue subprime mortgages to high-risk borrowers in order to fulfil unrealistic social and housing policies - borrowings which resulted in widespread default and triggered the crisis.

Regulatory requirements

The plethora of reports issued since the crisis have been equally unanimous (at least at the highest level) in putting forward proposals for addressing identified weaknesses; for example, enhancing the role of international standard-setting bodies such as the International Monetary Fund, the Basel Committee and the Financial Stability Board, developing global and regional mechanisms for identifying and addressing systemic risk and strengthening regulatory collaboration, co-operation and information sharing.

This priority agenda includes plugging the 'black holes' in the regulatory perimeter (hedge funds, credit rating agencies, off-balance sheet items, 'shadow banks', over-the-counter [OTC] markets, etc) and establishing international colleges of supervisors for systemically important institutions. For example, in the EU, there will be a new European Systemic Risk Council, a new European System of Financial Supervision and three new European authorities charged with the responsibility of developing common regulatory standards, overhauling the EU framework for information-sharing and overseeing member state implementation of EU-level directives and other regulatory requirements.

In general terms, there is strong support for these new proposals and widespread recognition that, in the aftermath of such a severe economic and financial crisis, the priority will be on enhancing systemic stability and increasing significantly the capitalisation of banks and other critically important institutions. However, there are concerns over the impact on market liquidity, innovation, diversity and, for customers and consumers, the costs of trading, investment and risk management. As Lord Turner, chairman of the UK's Financial Services Authority (FSA) put it, "how much we shift the trade-off deserves careful thought." This is largely because, as it was put in the De Larosière Group Report, over-regulation "slows down financial innovation and therefore undermines economic growth in the wider economy".

In reality, the issue is less about new structures but more about structural improvement and better rules, supervision and enforcement of rules. After all, the crisis had its genesis in one of the most highly regulated jurisdictions in the world, namely the US, and spread rapidly around the world, notwithstanding the existence of hundreds of regulatory authorities, armies of supervisors, tens of thousands of rules and a plethora of inter-regulatory memoranda of understanding and co-operative arrangements.

Proportionate responses

There is recognition in some of the various reports that have been issued since the crisis of the importance of a proportionate response. However, these are scattered references and the depth of commitment on the part of regulatory authorities and, indeed, governments, is difficult to gauge and, in some cases, distinctly questionable. The approaches to hedge funds and OTC derivatives are examples in point.

With regard to hedge funds, the vast majority of them have leverages typically well below that of banks and do not in general deal with retail customers or replicate the same risk to the system as banks. Nevertheless, the European Commission has put forward a draft directive that imposes regulatory requirements that are disproportionate, onerous and needlessly in excess of International Organisation of Securities Commission's standards for alternative investment fund managers. The directive also seeks to impose these standards extra territorially and has provoked allegations of protectionism. Hedge funds are recognised as having not been a significant or direct contributor to the causes of the crisis. Bringing them into effective regulation is important - but does not justify the imposition of a needless, punitive and damaging set of rules.

The approach to OTC markets has raised similar questions. Here again, there is a need to intensify regulatory oversight, impose more comprehensive trade reporting requirements and encourage central counterparty (CCP) clearing of standardised OTC derivatives.

Unfortunately, regulatory zeal for all contracts to be standardised (to make them eligible for CCP clearing), force them into electronic execution and impose additional capital and 'conservative' margin requirements on non-CCP cleared contracts will have the effect of reducing the number of tailored risk-management transactions in the market and increasing the cost of those that are left to the point where they may become uneconomic.

There is an increasing and serious risk that the regulators will themselves undermine the key post-crisis regulatory objective of enhancing the risk management capability of institutions and organisations. As it was put in the FSA's discussion paper 'A Regulatory Response to the Global Banking Crisis' (DP09/2): "Intervention by regulators explicitly designed to alter market structure needs to be taken with great caution."

Who's to blame?

Populism is also playing its part in influencing the 'targets' for regulatory repair. The tendency has been to blame the crisis on the investment banking model, when in reality it was not the fact of banking diversity that was the issue, but rather the excess to which elements of it were taken - exacerbated by failures in corporate governance and risk management controls on managing transactional risk.

Anti-speculator populism is also spurring the US drive to impose 'strict' position limits on non-commercial trading in commodity markets, notwithstanding that the vast majority of independent reports produced to date have attributed the long-term changes in commodity price volatility in the energy and agricultural markets not to speculative trading, but to problems and tensions in physical supply and demand.

The inclusion of offshore centres as a target for regulatory repair provides yet another example of politicisation. Clearly, there are justifiable concerns over the business and asset risks of firms dealing in poorly regulated offshore centres, but many emerging market economies suffer from inadequate regulation, yet there are no comparable proposals for imposing business constraints or additional capital requirements for them. The fact is that the crisis was caused by inadequate regulation in the major onshore financial centres - not the offshore financial centres.

There is also the question of how to deal with the post-crisis ambitions of the regulatory authorities for greater power and more discretion. An case in point is the debate over the regulatory perimeter. While, on the one hand, it is perfectly sensible to suggest that regulation should focus on economic substance rather than 'legal form', setting the regulatory boundary should surely be a matter for parliaments and not a 'movable feast' within the discretion of regulatory authorities (other than, for example, in the case of information gathering and group risk profiling). Subjecting organisations which do not carry financial services business to high cost rules could have serious consequences for their international competitiveness.

Moving forward

In a global business environment, it is self-evident that if banks and other financial institutions are to continue to be able to service the differentiated needs of an increasingly international client base efficiently and cost effectively, the programme for regulatory repair must be the subject of worldwide consensus. However it must be both balanced and proportionate, and that means:

- Sustaining market innovation, product diversity and consumer choice through the cycle of regulatory repair.

- Avoiding penalising the many for the mistakes of the few with regulations which would be economically damaging to organisations which pose no significant risk to the system.

- Delivering on the widespread consensus that the crisis must not justify a retreat to closed markets and regulatory protectionism by re-opening the 2008 transatlantic open market dialogue and extending it to other jurisdictions.

- Recognising that many regulated organisations are surviving on significantly lower levels of profitability and are heavily engaged in rebuilding their businesses.

- While recognising that new supervisory structures must be politically independent, the authorities must not be deflected away from their core objectives by ill-informed or politically populist views.

As the UK's FSA put it in DP09/2, the emergence of a sounder and more sustainable international banking system should be one "that engenders competition and will be capable of delivering the essential intermediation services that economies and consumers need". This is the balance that should lie at the heart of the programme of regulatory repair - but does it?

Anthony Belchambers is the chief executive of the Futures & Options Association