Column Fall & rise of financial regulation

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The global credit crunch is entering its second year. Fears remain high of another large banking casualty. It is a damning indictment of international financial regulation. A peculiar characteristic of financial regulation of the world’s largest banks, and one of the causes of its repeated failure, has been the divergence of practice from theory. Recent proposals by international regulatory bodies such as the Financial Stability Forum and the Institute of International Finance, the big bank lobby group, will only continue this divergence and condemn us to witness a repetition of this and future crises.

Should we care? While the RBI governor is increasingly invited on to the stage of global financial diplomacy, India’s regulators do not have a formal seat at the Basel Committee. Of course, international banks operating in India have to conform to Indian regulations and Indian banks have not been caught out by the subprime crisis. But India’s banking and capital markets are not an isolated island in the sea of international capital. The credit crunch will strangle the flow of private equity capital from abroad, and this may explain the surprising correlation of the rupee’s external value with the development of the credit crunch. Moreover, when Indian banks venture abroad they will have to conform to international rules and will complain back home of the hassle of conforming to two sets of rules. We should care.

In theory, it is generally accepted that the core purpose of financial regulation is to mitigate systemic risks, like a global credit crunch. In practice, however, regulatory rules set out by the Basel Committee of Bank Supervisors are focused entirely on risk-taking by individual firms.

It is a failure of composition to think that by encouraging good behaviour at the company level, the system will inevitably look after itself. One of the striking things about the report requested by the Swiss Federal Banking Commission into the key facts leading to UBS’s subprime losses, was that much of what UBS did to get into difficulty was considered to be best practice for individual firms. Banks put their resources in places where their risk management systems, using publicly available data, told them it was safe, generating large system-wide concentrations. When confronted with this point, regulators have asked my colleagues and I, “But what would systemic regulation look like?” The following new proposals provide a flavour.