Multiple financial sector reform measures are being debated and progressively implemented in various countries. Last week, in particular, saw a number of regulatory events and announcements, including the reconciliation process of the US Congress?s House and Senate versions of a financial sector reform Bill, now down to the wire. Hard on its heels came the announcement by the UK chancellor of the exchequer of sweeping financial sector reforms. Probably the most startling of these, largely because of the growing body of favourable opinion over the past decade, was a proposal to dismantle the Financial Services Authority (FSA), the UK?s financial super-regulator, and restructuring the resulting bits and pieces in new configurations.
Closer home, in India, an executive ordinance sought to provide resolution to the dispute between the capital markets and insurance regulators (which might dilute a proposal to bring all organised financial trading under one regulator).
A fair bit of column space has already been dedicated to these seemingly disparate developments; what does this column add? It seeks to emphasise one aspect of reforms?the regulatory oversight architecture?that would implement the broad principles of reforms. The proximate reason for this emphasis is the ?Squam Lake Report?, unveiled at a conference last week to discuss the recommendations of an influential group of economists, who had got together in the Autumn of 2008 to deliberate on the future of the financial system.
The broad focus of the report is on the following aspects: a systemic financial markets regulator, a new financial markets information infrastructure, regulation of retirement savings, reform of capital requirements, regulation of executive compensation, an expedited mechanism to recapitalise distressed financial firms (regulatory hybrid securities, improved resolution options for systemically important financial institutions), credit default swaps, clearing houses and exchanges, prime brokers, derivatives dealers, and runs. The reason we take the report seriously is that it seeks to provide the intellectual moorings of the reform efforts. Moreover, since the reform legislation in the US Congress is broadly on similar lines, the outcome there is likely to influence thinking on reforms across the globe.
This column highlights the conclusions of the report related to the proposed regulatory and oversight architecture. Borrowing from Ben Bernanke, who addressed the conference, one of two the central principles that guided their recommendations was a need for regulators to focus on the soundness of the financial system as whole, and not merely on the soundness of individual financial institutions. In the jargon of economists and regulators, supervisors need a macro-prudential as well as a micro-prudential perspective. This is nothing new, but needs to be looked at afresh, in the light of the US and UK proposals, particularly the organisational architecture and mechanism of that oversight.
One broad trend is clear, i.e., a move towards a unified oversight mechanism, based on the key premise that ?only independent central banks have the broad macroeconomic understanding, the authority and the knowledge required to make the kind of macro-prudential judgement that are required.? The failure of large, complex and interconnected financial firms can disrupt the broader financial system and the overall economy, and such firms should be regulated with that fact in mind. Likewise, the costs of the failure of critical financial infrastructure, such as payments and settlements systems, are likely to be much greater and more widely felt than the costs imposed directly on the owners of and participants in those systems.
The obvious question would be which entity can best monitor this systemic soundness? The report considers the central bank?in the US, the Federal Reserve?as the entity best qualified to perform this super-regulatory function. This was, coincidentally, also the reconciled outcome of the US reform Bill, which provides for the creation of a Financial Stability Oversight Council, composed of all the existing regulatory bodies, but with the Federal Reserve seeming to play the lead role. In India, a similar oversight body is sought to be established: the Financial Stability and Development Council. What is different in this case is that the crafters of the requisite legislation probably do not see this body as a super-regulator, but primarily as a mechanism for regulatory coordination.
This structure is somewhat different from the scheme proposed in the UK, where the Bank of England is proposed to be made the super-regulator, with the micro- and macro-prudential oversight tasked to a Prudential Regulatory Authority and a Financial Policy Committee, respectively, within its ambit.
Broad principles are fine, the difficulty is in agreeing on the details, as is evident in the reconciliation process and lobbying currently taking place in the US. Understanding the operational implications of the new working arrangements, specifically the statutory powers of the super-regulator to demand detailed financial information from key, big, interconnected firms, will be a lengthy process.
The author is vice-president, business & economic research, Axis Bank. These are his personal views