A mid-term reality check

Updated: Jun 12 2014, 05:40am hrs
Lax financial regulation and supervision took the major blame for the global financial crisis (GFC). This initiated the most far-reaching reform in advanced economies since the Great Depression under the watchful eyes of the G20, supplemented by national initiatives in major jurisdictions.

The G20 approach was comprehensive, logical and progressive, based on four pillars: agreeing new regulations, supervising their implementation across major jurisdictions to avoid regulatory arbitrage, formulating resolution mechanisms to avoid taxpayer bailouts in case systemically important financial institutions (SIFIs) failed, and periodically stress testing the new structure for robustness.

There is notable progress on the first pillar through the Basel III capital and liquidity standards for commercial banks focused on strengthening both the quantity and quality of capital, introducing new leverage and liquidity ratios, and improving risk management, governance, transparency and disclosure norms to insulate them from the activities of shadow banking that triggered the GFC.

To address the third pillar, the Financial Stability Board (FSB) released guidelines and a list of global SIFIs whom national regulators could subject to greater regulatory oversight. The Dodd-Frank Act (DFA) in the US put in place a framework to regulate any financial institution (FI) determined to be a SIFI and also for their orderly resolution, as required. On the fourth pillar, the FSB has moved to strengthen the Financial System Assessment Programme of the IMF and stress tests are now routinely used by national regulators. The progress on the second pillar is, however, patchy.

Basel III

The quick international consensus on the new Basel III norms is remarkable, notwithstanding criticism from both sides of the ideological spectrum. Intense lobbying to dilute Basel III stringency is backed by the argument that since the economy is struggling to get back to its feet, the aggressive regulatory push would only damage the recovery through accelerated deleveraging. The quick rebound of shadow banking to pre-crisis levels is also linked to the stringency of Basel III.

Critics of Basel III have emphasised on some additional concerns. First, it is ironic that although the source of the GFC lay in shadow banking, it is commercial banking that has been fixed while regulation of shadow banking remains work in progress.

Second, Basel III continues to aid pro-cyclicality through the principle of mark-to-market (MTM), notwithstanding an element of counter-cyclicality introduced through revised ratios.

Third, although financial risk, asset inflation, bubbles and leverage are all correlated, Basel III does little to prevent build-up of leverage in the financial system. It does endeavour to disincentivise commercial banks from taking risky debt through higher risk weights and also to rein in leverage through a new leverage ratio. The attempt to prevent overall build-up of leverage is, however, feeble as high levels of leverage underlie the financialisation of advanced economies through rapid expansion of claims and reclaims of the same underlying asset between FIs rather than through expansion of claims on real assets that expand production frontier. Basel III fails to distinguish between good and bad forms of leverage or to contain total leverage in the system, which includes sovereign debt and shadow banking at levels commensurate with economic growth. Fiscal policies that encourage debt over equity through tax asymmetric treatment are also unlikely to change any time soon.

Shadow banking and the Volcker Rule

Recognising that sources of systemic instability in the financial system may remain outside commercial banking, the FSB is developing a framework for reining in shadow banking. It has released policy documents for strengthening oversight and regulation of shadow banks that may be finalised at the ninth G20 Summit in Brisbane, in November 2014. The G20 initiative on shadow banking, however, remains work in progress.

New components of shadow banks like less leveraged real estate investment trusts, finance companies, business development companies, sovereign funds and private equity have emerged; while old instruments like ABCPs, SIVs and CDSs are now becoming extinct. Whether shadow banking in the post-crisis period is less destabilising than what it was prior to the crisis is, however, arguable. Be it as it may, given the experience with shadow banking during the recent crisis, and because it does not have the liquidity buffers of commercial banking to prevent runs and panics, regulators have agreed on the need for tighter control of shadow banks. Apart from DFA facilitating regulation of non-bank SIFIs, there are major national initiatives in the US (Volcker), UK (Vickers) and the eurozone (Liikanen) that ring-fence the shadowy proprietary trading from the commercial banking arms of FIs.

Too big to fail (TBTF) and resolution

SIFIs have assumed a special role by virtue of their size, complexity of operations and the volume of transactions handled across a wide range of products, services and markets. They play a critical public utility role in the smooth functioning of financial markets and are, therefore, considered TBTF as problems within a single SIFI can trigger system-wide crisis. The near collapse of the American financial system between 2007 and 2008 following the decision by the US Fed and Treasury to not bail out Lehman Brothers underscored this systemic fragility.

National regulators are now inclined to impose greater oversight and higher capital requirements for SIFIs. The FSB has stepped in with a list of global SIFIs and to prepare a roadmap for recovery and resolution planning of global SIFIs through the formation of crisis management groups. The US has a concrete roadmap vide orderly liquidation authority (OLA) under the DFA. The OLA holds shareholders and creditors responsible for the losses of FIs so that taxpayers funds are not used for liquidation purpose. This implies that bank survives through bail-in by creditors rather than bail-out by taxpayers.

In order to facilitate orderly liquidation under DFA, all FIs classified as SIFIs are required to submit resolution plans (living wills) to regulators. The living will lays down the roadmap for its orderly resolution, during liquidation. Several of the USs largest banks have released their blueprints on how they could be dismantled after its collapse.

The robustness of OLA can only be tested in an actual financial crisis. There are several imponderables like probable knee-jerk market reaction to the news, absence of cross-border resolution framework, failure of living wills when faced with market-wide crisis and inherent difficulty in capturing all possible risks. Although these resolution mechanisms might minimise the likelihood of taxpayer bail-out, they also result in an implicit subsidy for SIFIs, lowering their borrowing costs relative to smaller banks. There are, therefore, fears that the implicit government guarantee enjoyed by SIFIs may result in riskier behaviour.

The SIFI problem is particularly acute in the EU with several individual bank assets exceeding the size of their respective sovereign GDP, making the SIFIs too big to be bailed out as their central banks do not have the power to print euros. This vicious loop between weak banks and weak sovereigns is impelling the EU towards a politically challenging single supervisor, single resolution and a harmonised deposit insurance system, and also lies behind the European Commissions backing for a Franco-German initiative to levy Financial Transaction Tax to strengthen the fiscal hand of eurozone governments. These issues call for a stronger fiscal union.

The overall focus of regulatory reform has been on strengthening capital buffers and resolution mechanisms to avoid taxpayer bail-outs. These buffers may be effective in business downturns, but may never be enough to deal with systemic risks of a financial crisis, when assets are marked down and markets are so dysfunctional that taxpayers may still have to step in. The payments system is so closely integrated with the financial system that together they can be considered a public utility underwritten by the taxpayer. It is arguable whether the financial system is now safer despite the new regulations, as the underlying source of heightened instability, namely financialisation of the economy to the extent that there is little correlation with economic growth, remains unaddressed. A new source of instability emanating from a monetary policy framework unresponsive to asset price inflation has accentuated the disconnect between the real economy (economic growth) and financial markets (asset prices).

To summarise, the G20 financial reform agenda is undoubtedly ambitious. But will this time be different Six years on, the outcome is mixedwork in progress at best, and a tale of progressive dilution at worst on account of the putative incestuous relationship between the Treasury and Wall Street. The overwhelming concern is that as normalcy returns, business would be as usual. Basel III might be diluted. The moral hazards inherent in the banking emolument and credit rating systems remain unaddressed. Cross-border harmonisation and cooperation to obviate regulatory arbitrage remains weak. Shadow banking is back on its feet even as commercial banks struggle with new regulation. The issues of pro-cyclicality and over-leverage continue to haunt regulators. Banks today are bigger than what they were before the crisis due to M&A. In the eurozone, with its flawed monetary union, several banks are too big to be bailed out by their sovereigns, and no FI seems small enough to be allowed to fail because of interrelatedness of the financial system. An unreformed monetary policy framework also continues to put financial stability at risk.

(This is the first of a two-part series)

Alok Sheel & Meeta Ganguly

Alok Sheel is a civil servant and Meeta Ganguly is an independent researcher. Views are personal