The global financial crisis has taken a heavy toll, both in terms of lost output and the erosion of financial wealth at a personal, national and international level. Four years on, the regulators continue to ponder how best to aid the recovery of the battered financial system and avoid a recurrence of any such financial catastrophes in the future.
No wonder we have seen a slew of regulatory responses aimed at addressing the vulnerabilities of financial markets and institutions. For instance, the Basel Committee has endeavoured to improve the quality and transparency of banks’ capital bases, introduced a minimum global standard for funding liquidity, and proposed a leverage ratio.
The Volcker, Vickers and Liikanen commissions in the US, UK and EU, respectively, have attempted to tame the ‘casino’ nature of investment banks by prohibiting them from trading for their own profit and ring-fencing them from their retail counterparts.
The Financial Stability Board has also proposed ways to build an effective regime to handle and resolve the failure of systemically important financial institutions. Recently it has also called for greater oversight of the $67,000bn-world of shadow banking. Meanwhile, at national levels, financial regulators have responded in a variety of ways in their quest for financial stability.
Breaking the cycle
These efforts by regulators around the globe, both at a national and supranational level, remind us of the challenges we face in building an architecture that is capable of withstanding financial turmoil such as that we have experienced in recent years.
Against this backdrop, I would like to reflect upon how we should best approach financial regulation, along with sharing a few examples from our own endeavours at the Central Bank of Kuwait (CBK).
First, a regulatory response, particularly a post-crisis one, needs to avoid a knee-jerk approach to fixing the financial system. While it is tempting, if not compelling, under social, economic and political pressures to overreact after a crisis, this cyclical approach to regulating needs to be eschewed.
Such an approach is likely to be too late to deflate the bubbles and too stifling to give the recovery a chance. Regulators cannot compensate for their complacency, whether perceived or real, in the good times by overreacting in the bad times. Rather, this runs the risk of accentuating the very cycles that financial regulation should ideally be curing. For instance, if profligacy led to massive debt accumulation during boom years, an intransigent take on austerity in the midst of recession may do little more than exacerbate the downturn.
CBK, being cognisant of these complications, has tried to adopt a balanced and gradual approach to implementing financial regulation, aiming to improve the resilience of the system through its rules, but without jeopardising the recovery or undermining the solvency of our financial institutions. For instance, over the past few years we have required banks to keep building precautionary provisions, over and above the specific and general provisions, to help them better manage any potential decrease in their asset quality that is likely to take place in times of slack economic activity.
Culture shift
Second, we need to address the culture where gains are personal while losses are borne out by the public. In this regard, the principles of sound compensation practices to reduce incentives towards excessive risk-taking, issued by the Financial Stability Board in April 2009, are a step in the right direction.
Similarly, the Basel Committee’s recent efforts to strengthen the quality, consistency and transparency of bank capital are commendable. However, at CBK, since the mid-1990s we have required our banks to maintain a capital adequacy ratio (CAR) of 12%, well above the global norm of 8%. Furthermore, the bulk of our banks’ capital consists of core Tier 1 capital. While our CAR requirements might have appeared too conservative in good times, this prudence has served us well. Capital is undoubtedly expensive, but not more so than bank failures and consequent bailouts.
Third, it is desirable to aim for fewer but more comprehensive regulations that can accommodate various objectives, taking into account the interconnectedness of banks’ myriad activities. Failure to integrate regulations can result in numerous rules, which may not only be self-competing and confusing, but can also create opportunities for regulatory arbitrage. This necessitates that regulators take a holistic view of the measures they adopt, as the number of rules can be reduced without compromising their effectiveness.
This was the consideration behind CBK’s recent attempt to refine its existing loan-to-deposit ratio (LDR). Typically, a simple LDR is used to set a ceiling (or even a floor if so required) to influence credit growth. Yet this approach treats different banks similarly by allowing them to lend the same percentage, irrespective of the maturity profiles of their deposits.
Instead, we have formulated a multipurpose measure, linking bank lending to a wider and stable funding base. To start with, we have used different haircuts for deposits of different maturities, allowing long-term deposits to be 100% loanable (ie. no haircut), but applying a haircut of 25% on short-term deposits. This has incentivised banks to mobilise deposits with longer tenors, thus complementing our existing liquidity regulations aimed at further reducing maturity mismatches. Moreover, we have linked bank lending to an expanded funding base by including bonds and Islamic bonds, or sukuk, to help develop the capital market.
Long-term view
Fourth, formulation of financial regulations should take into account long-term consequences, particularly the unintended ones. Understandably, all regulations have unintended consequences, which are much harder to visualise than the intended ones. That is why it is important to strive to design regulation that envisages what might go wrong.
Basel I is a case in point. While the capital accord made a contribution in terms of standardising the capital requirements for banks across the globe, it also incentivised banks to restructure their portfolios in order to reduce their regulatory capital needs, without curtailing their risks.
Fifth, regulators need to appreciate that desirable outcomes may not be immediately practical. The case of deleveraging is quite illustrative in this regard. While it is indeed desirable to ensure deleveraging in consumer, banking and government finances which has built up during the past decade, it is unlikely to be achieved without compromising economic recovery, particularly in times of slack growth.
Sixth, regulators at domestic levels need to understand that adopting global best practices still requires a sound understanding of the local environment. Domestic regulators cannot outsource their job when it comes to taking effective measures. The banking industry is quite dynamic so that any regulation can become obsolete soon, requiring domestic regulators to build the capacity to respond in time before it is too late.
Clearly, effective regulation of the financial system is a tall order, even more so in today’s complex world of finance. Yet, as we have seen and are continuing to witness, the cost of poor regulation is simply colossal. Some estimates suggest that since its onset in 2007 until the present day, the global financial crisis has cost the world a whopping $15,000bn and counting. This scale of financial loss, along with the attendant socio-political consequences, is a strong enough reason to prompt the regulators to rise to the challenge of ensuring a stable financial system that is also conducive to growth and long-term development.
Dr Mohammad Y Al-Hashel is the governor of the Central Bank of Kuwait
