When the world’s financial system suffers a near-fatal heart attack, how should it be rehabilitated? This is the question confronting governments and regulators worldwide as the global economy lurches from one disaster to another. Finding an answer to this question will be an unenviable chore for these parties, not least because few onlookers are likely to be impressed when they do. But it is also a task fast becoming overwhelmed by the politics of protectionism, as regulators move to promote their existing powerbases and governments adopt stances that hint of a creeping financial nationalism.
Disorganised regulation
In recent months, the woes of the Western financial services industry have been upgraded from a crunch to a crisis to a global economic drama. November’s meeting of the G20 fixed the ‘global’ in global financial crisis, underlining as it did the unprecedented physical and political distance that Wall Street’s contagion has spread. Fed by global trade flows and compounded by an extraordinary growth in cross-border investment, the financial crisis has exposed the complexity of modern financial markets.
At a recent event held by City law firm Allen & Overy, commissioner Troy Paredes of the Securities and Exchange Commission (SEC) more or less admitted that this has not been fully appreciated by regulators: “The world is extremely interconnected, perhaps in ways and to a degree that we had not previously understood,” he says.
The problem has not been helped by the “disorganised” nature of global supervisory structures, as industry veteran Charles Dallara, managing director of industry best practices group the International Institute of Finance (IIF), describes it. The US alone has eight separate regulators, although US Treasury secretary Hank Paulson has expressed a determination to converge many of these functions. Meanwhile, Europe’s supervisory regime has been condemned by the Centre for European Policy Studies (CEPS), a leading think tank, for its “multitude of supervisory authorities” that has led to “confusion, misunderstandings, and even mistrust”.
Likewise, the evolution of an over-stuffed rag-bag of global supervisory agencies has led to fatal inconsistencies in global regulatory oversight, resulting in the well-recognised act of “regulatory arbitrage” on the part of artful financial institutions.
Globo-cop?
Despite historical attempts to co-ordinate efforts through informal ‘colleges’, the resulting collective momentum has simply proved inadequate in the face of the present crisis, says the IIF’s Mr Dallara. “Right now, we do not have sufficient energy and authority around the college of supervisors to create much consistency of operations,” he says. This systemic disharmony, combined with the complex globalisation of capital markets, has led several industry luminaries to argue strongly that the creation of a well-staffed and properly resourced international or ‘super’ financial regulator is now timely.
Such an entity would provide a mechanism by which to co-ordinate between jurisdictions and identify significant inconsistencies across national regimes. It would also help mitigate the dislocation between global macro-economic policies, identified as a key factor in the crisis: several agencies issued reports prior to the crisis, in which they identified inflated asset prices and the rampant onset of bank leverage as worrying vulnerabilities. “But the market was not listening and the consequent action needed from supervisors did not take place,” says one central banker.
Ensuring that macro-prudential analysis is better reflected in regulatory frameworks is something that all parties appear largely to agree on, and a process over which a global regulator might helpfully preside. More importantly, a global regulator would be better equipped to resist the political interference to which many western regulators have been subject in recent years. For example, a growing criticism of the SEC – whose competence is now in doubt following a series of oversights – is the extent to which the once strongly independent regulator has become politicised as a consequence of the competitive Congressional funding regime.
Nor is this phenomenon exclusive to the US. Howard Davies, director of the London School of Economics (LSE) and former chairman of the UK’s Financial Services Authority (FSA) also notes, for example, that London’s much-feted ‘light-touch’ regime, as it is frequently described, was a ministerial invention. “It was never ever said by the FSA,” he says. “Ministers used to say it, which used to drive me mad because I didn’t know what it meant. It struck me as being remarkably unhelpful. You either regulate or you don’t.”
At its November summit, the G20 – which conspicuously failed to address the issue of political contamination – called for “intensified international co-operation among regulators” and the “strengthening of international standards,” as well as information-sharing across jurisdictions. But the world’s economic elite stopped short of recognising arguments for the creation of a global regulatory body, a proposal that has been dismissed by a number of regulatory agencies with striking (if not disinterested) clarity.
“It is not going to happen. We are not going to see a super-regulator in a structural sense,” says Jane Diplock, chair of the executive committee of the International Organisation of Securities Commissions (IOSCO). Despite identifying a lack of global regulatory co-ordination as a chief force in the crisis, Eddy Wymeersch, chair of the Committee of European Securities Regulators (CESR), agrees that the emergence of a single, co-ordinating global body is now unlikely.
Musical chairs
It is unsurprising that the existing regulators are so quick to reject the feasibility of this proposition. The crisis offers a unique opportunity for many agencies to jostle for what will almost certainly be a well-funded seat at the top table of the world’s revamped regulatory order. Even if the practical implications of erecting a resource-hungry global regulator were not so complex, the creation of such an entity is unlikely to be in the political and financial interests of the prevailing regulatory bodies. Most watchdogs are lobbying for an expanded role in the refurbished regulatory regime, and many, such as the UK’s FSA, are beefing themselves up and talking tough.
Amid the clamour, it seems clear that the International Monetary Fund (IMF) and the Financial Stability Forum (FSF) will emerge as key focal points, with the IMF assuming a more wide-ranging role including a number of cross-border co-ordinating functions. Following G20 calls to expand its membership, the FSF is taking steps to encompass and represent emerging economies and the growing weight of their financial markets.
Many national and international agencies are also taking their lead from the G20 and are devoting their efforts to driving forward what Ms Diplock refers to as a “virtual super-regulator” comprising a network of regulatory arrangements based on “mutual recognition”. This provision, by which domestic regimes allow for cross-border co-operation and enforcement, is an attractive compromise, which allows national regulators to expand their international presence but to reduce, to some extent, their operational costs.
This rather sinuous model represents the most realistic incarnation of a future global regulatory infrastructure, says Ms Diplock, the roots of which have already taken hold through bilateral and multilateral agreements between the US, the EU, Australia and Canada. The SEC, for example, has said it regards mutual recognition as an increasingly important tool for dealing with international issuers. Emerging markets are also embracing this approach, adds Ms Diplock.
In Europe, meanwhile, tighter internal co-ordination between member state supervisors has fast become a familiar platitude, although this time France, a long-time champion of a single European regulator, is serious. In response to growing pressure from European ministers on this issue, the European Commission has established a high-level group to assess the future of Europe’s supervisory architecture, although its findings will not be unveiled until spring.
The resurgence of nationalism
Even so, there are those in the industry who believe talk of enhanced co-operation is just that. One well-placed source warns that beneath this affable veneer, the forces of nationalism are gaining the upper hand.
This is particularly true of Europe, where the indecorous scrap over Fortis underlined the extent to which insidious protectionism prevails within the union. The Banker understands that, following a slew of highly unpopular, nationally funded recapitalisations, national governments are trying to appease taxpayers and ring-fence funds by tacitly forbidding banks to transfer emergency liquidity to subsidiaries in other regions.
Not only does such protectionism threaten “to unravel the single market”, warns the CEPS, it could put the very concept of the international bank at risk. Many industry leaders are now worried that the pressure for international harmonisation will be no match for the powerful national reflex. “There is a real struggle under way between these two forces and I’m not sure who is going to win,” says Mr Dallara.
Where concrete action is concerned, nationalism is in the ascendancy. Take the Swiss Federal Banking Commission (SFBC), for example. The Swiss regulator recently announced that the country’s two economic pillars, UBS and Credit Suisse, will have to comply with a new, non-risk-weighted minimum leverage ratio of 3%, designed to cap the banks’ level of debt, irrespective of the risk. Since the regulator does not wish to deter the banks from lending within Switzerland, however, the country’s domestic lending activities are exempted from the leverage ratio. But the Swiss regulator did not stop here. It also announced plans to hike the capital adequacy target ratio for UBS and Credit Suisse to between 50% and 100% above the international minimum requirements found under Pillar I of Basel II, which demands that an institution’s capital must exceed 8% of risk-weighted assets.
Understandably, the Swiss regulator has taken steps to shore up institutions central to its economic well-being. But its move reflects a widespread recognition that the capital buffers, as prescribed by Basel II, have proved woefully inadequate in the face of a sustained crisis of confidence, in which Tier 1 capital has fallen short to the tune of $2000bn dollars worldwide and counting.
The IIF, the FSF and central bankers agree that future capital cushions must be more robust than those historically prescribed. “The guiding principle that runs through our recommendations is the need to recreate a system that operates with more capital per unit of risk than has historically been the case,” says Svein Andreson, secretary general of the FSF.
The Basel Committee on Banking Supervision (BCBS) is busy addressing this issue, he adds, and has recently declared, under a new strategy unveiled in November, that its primary mission, among other goals, is to strengthen banking capital buffers, including the “quality” of Tier 1 capital, and to ensure the buffers are more absorbent of systemic financial shocks in future. (See interview with Nout Wellink, chairman of the BCBS)
Going it alone
None of this would be particularly controversial, were it not for the fact that the Swiss response suggests that many local regulators are growing increasingly impatient, and may be unwilling to wait for the great and the good in Basel to make up their minds. Mervyn King, the overworked governor of the Bank of England, made this clear on November 25 in a testimony to the UK Parliament’s Treasury committee. During the meeting, he blamed the Basel regime’s “built-in” element of pro-cyclicality for exacerbating the crisis by forcing banks to reduce lending in order to build up their capital reserves. “That, everyone I think agrees, is the wrong way to go,” he said.
Another source at a large central bank agrees that the pro-cyclicality of Basel II has been a concern since the accords were first outlined. “More work is clearly needed,” he adds and both the Basel Committee and Europe’s Economic and Financial Affairs Council are investigating means by which capital ratios may be adjusted in order to constrict booms and mitigate busts.
Throughout the crisis, the UK tripartite authorities (the Bank of England, Treasury and the FSA) have taken measures to offset the pro-cyclical effect of Basel, said Mr King, using the FSA to make judgements on a bank-by-bank basis: in other words, it has had to improvise. Under its self-authored framework, the FSA has defined the meaning of core Tier 1 capital and applied risk-weighted ratios as it sees fit. The Treasury has stressed that this framework, devised under duress, is temporary, while the longer-term capital regime will be reviewed in the first quarter of 2009. Having distanced itself from Basel II, however, there are some who believe the tripartite authorities might well take a unilateral approach to some, if not all, of the capital requirements.
The trading book is one area in which, says a source, the FSA “can and very probably will” go it alone when revising capital requirements. It is an area over which the FSA has expressed serious concern. “Banks have taken losses on the trading book that are many times larger than the capital required: something is wrong there,” says Thomas Huertas, director, banking sector at the FSA.
Under the current market risk framework prescribed by Basel II, it is assumed that all trading book instruments are liquid, while in practice this is not the case. Some argue that because such assets cannot be liquidated at mark-to-market, a capital charge ought to be held against illiquidity risk. The Basel Committee has suggested amendments to the trading book, but the dwindling credibility of the Basel regime leaves the future of these and other recommendations in doubt. More broadly, FSA chairman Adair Turner has also suggested that the authority might consider introducing a Spanish-style anti-cyclical regime.
Ring-fencing liquidity
To place too much emphasis on capital buffers is to miss the point, however, as the problems relating to the trading book highlight, points out the LSE’s Mr Davies. “In times of stressed liquidity you can have a pretty high Tier 1 capital ratio and still run into significant trouble. I don’t think that the concept of Tier 1 capital is in itself invalid but it will have to be linked to a tighter approach to liquidity.”
In a marked departure from its 2000 guidance, the BCBS also issued draft principles to address just this issue. Among other things, these principles, published in June 2008, expect to “raise standards”, as the committee puts it, across a range of liquidity risk management functions. Taking its lead, on this occasion, from the BCBS, the FSA – which has presided over a banking industry addicted to the now arid interbank lending market – published its own consultation paper in December, in which it also outlined a far-reaching overhaul of the liquidity requirements for UK financial institutions.
Under the proposed rules, which are almost certainly destined for the FSA’s ballooning Rulebook, banks will have to adhere to a new framework for liquidity risk management in which a range of risks, from the “stickiness” of wholesale and retail funding, to off-balance-sheet activities, must be self-assessed. Mr Huertas says the measures will help discourage “an undue reliance on overnight funding” and will “encourage banks to raise longer-term funds”.
But they will also require banks to increase the rather anaemic proportion of highly liquid assets that they presently hold on their books (thought to be in the region of just 2%) by taking on less risky assets such as highly rated government bonds. This will doubtless prove handy for what is an ever-indebted UK government, but it is likely to increase dramatically the cost of operating in the UK.
In fact, the FSA estimates that the mainstay of UK banks could lose £1.3bn ($2bn) to £5.3bn in revenue as a result of holding these lower-yield assets which, as the FSA acknowledges, may serve to reshape some banks’ business models. If this seems to undermine, rather than support, the interests of UK banks, the FSA’s measures will also attempt to protect UK creditors by demanding that UK-based subsidiaries of international banks are self-sufficient where liquidity is concerned.
The watchdog hopes that these provisions will prevent another Lehman Brothers-style debacle, whereby the US-based parent bank sucks up the liquidity of its subsidiaries overnight, leaving creditors highly vulnerable in the event of bankruptcy. But it will likely make London a less attractive venue for many international banks.
To this extent, the measures smack not so much of the self-preservation that has characterised regulatory responses worldwide, but highlight the mistrust with which regulators regard their peers in other jurisdictions. If the FSA felt confident, for example, that the US regulators could be relied upon to enforce robust liquidity requirements in New York, it might feel less inclined to replicate these efforts in London.
A lack of accountability
As the FSF’s Mr Andreson points out, Basel II’s capital regime also offered incentives to provide liquidity to off-balance-sheet entities, the risk of which was, as it transpired, unclear. This is another area that the Basel Committee is attempting to redress, he says. “New accounting standards for the derecognition of off-balance-sheet assets as well as the need to consolidate off-balance-sheet entities, is coming from the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB), which will remove the incentives to do securitisation activity off balance sheet. That should be coming to an end,” he adds.
IASB vice-chairman Tom Jones recognises that the widespread criticism relating to off-balance-sheet entities is “probably legitimate”, but also believes the disclosure requirements need to be revised. The IASB has recently issued proposals on this issue. “The jury is out. We all think that there are areas that we have to improve, such as disclosure requirements, and we’re working hard on that,” he says.
More controversial is the future of fair-value accounting, the standard under which the notional value of assets held on the balance sheet are ascertained by marking them to market. Many market-watchers argue it was this requirement that led to a precipitous downward spiral by forcing banks to take write-downs based on what have been artificial market values, thereby making the markets more illiquid and depressing asset values further. This looks less likely to be revised significantly, says Mr Jones. “Our response is that the balance sheet and the profit and loss are based on today: as of today, this is the real value and this seems to be what investors want,” although tax preparers, he notes, take the opposite view.
“We need to further develop fair-value accounting so that people have better guidance as to how you treat these instruments and possibly develop better models as to how you can value them,” adds Bart Capeci, partner at international capital markets, Allen & Overy.
What good will come of all this collective rumination is still unclear: public, political and market disillusionment with the prevailing regulatory regime and its authors is no longer just palpable, it is positively toxic. Resisting the call for self-interested action, and the ever-strengthening reflex towards unilateralism, will be crucial if the world is to receive the regulatory regime it so badly needs, if not deserves.
