In summits such as the G-20, one of the things that you can safely predict even before the meeting begins is that the world leaders would term it a ?success? in the end, irrespective of their efficacy or utility. More often than not, summits such as these, produce a press release that makes it seem as if the talks have accomplished something tangible. In the current distressed economic conditions, it was expected that the world leaders would attempt to sneak through without a damning indictment from all the constituents who are worse off by the current crisis.

One of important aspects that the summit focused on was to change the compensatory regimes in banks. Earlier, compensation was linked to short term profits and was dissociated from how it affected the long-term viability of the financial institution. The G-20 leaders suggested the concept of deferred compensation which make incentives a function of how decisions taken today span out over a longer horizon. Only if they are beneficial over the medium to long term, should bankers get credit for their work and be monetarily compensated. The G-20 leaders would do well to apply the rule to themselves. Instead of issuing self-congratulatory statements, they might as well wait to see if the regulation that they are putting in place now have indeed been beneficial and what tangible good has it done to the financial system. So let?s quickly assess the difficulties in regulation the G-20 is proposing which needs to be got through before it can pat itself on its back.

The G-20 agreed that the level and quality of minimum capital requirements will increase substantially over time. How much is the difficult question because raising it too high in regulatory over-enthusiasm might adversely affect the banking industry and therefore the economy. The G-20 agreed that capital requirements will operate countercyclically. That means, financial institutions will be required to build capital buffers above the minimum requirements during good times that can be drawn down during more difficult periods. Well, how do you define countercyclicality? Would that be one measure that fits all financial institutions? How do we know that we are currently in up-cycle or down-cycle? If you do a poll today of leading economists, half would say that we have seen the bottom of the economic cycle and are on our way up. The other half would say that there is more economic pain to come and there are more lower troughs ahead. If there is some quantitative model that predicts cycles accurately, I would be interested to know. If regulators identify the economic troughs beforehand, that is half the problem solved. The trouble is, nobody knows how and when these downturns choose to make their appearance and how severe they can be.

The G-20 identified that regulation should be put in place that can make global liquidity more robust. A new regulatory framework has been suggested that would ensure that global banks have sufficient high-quality liquid assets to withstand a stressed funding scenario. A liquidity coverage ratio that can be applied in a cross-border setting has been recommended. The crisis did demonstrate that adequate liquidity is a prerequisite for financial stability. Cross-border flows are often pretty vulnerable during financial crisis. However, putting in place a liquidity coverage ratio underestimates the means by which international banks manage their liquidity. Post-Lehman-default there was substantial lack of liquidity in US dollars. However, banks found it less difficult to get funding in euro or yen. So, having a one-size-fits-all liquidity ratio for all banks globally, may not be efficient.

The G-20 also deliberated on the need to reduce systemic risk of institutions that are ?too big to fail?; or, more correctly, too big and too complex to fail. The measures suggested have been to include specific additional capital requirements as well as stricter prudential requirements.

More complicated regulation more often than not fosters convoluted financial systems. For instance, regulations in bankers pay might result in multifaceted pay structures that more or less maintain the pay-out levels. Similarly, imposing additional capital requirements on ?too big to fail? financial institutions may result in increased intricacy of group structures. It is difficult to see bank shareholders let go an opportunity to grow their business just because the bank is nearing the threshold levels of ?too big to fail? that regulators may specify. Likewise, if there is a dearth of liquidity in a particular currency, banks may want to lend that currency through the foreign exchange market using products like Fx Swap to make a good profit. Since products like Fx Swaps are off-balance sheet items, the liquidity of the bank in paper may be high, but in reality may be lower than what the ratio might suggest. The regulators would do well to recap how the market participants used the credit derivatives market to do regulatory capital arbitrage during the earlier Basel-I regime. In general, market participants tend to outsmart the regulators. A complex regulatory regime provides many more avenues for arbitraging the system. In the world of regulation, complex isn?t necessarily better.

Only time will tell if the new set of regulations would make the world of finance less risky or not.

The author, formerly with JPMorganChase?s Global Capital Markets, trains finance professionals on derivatives & risk management