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.
First, while financial institutions are encouraged by supervisors to conduct thousands of stress tests on their solvency, few are conducted by the regulator on a system-wide scale. If it is possible to have system-wide stress tests on the impact of Y2K, or of avian flu, why not on liquidity?
The regulator should conduct system-wide stress tests of those scenarios most likely to produce systemic stress?such as a cyclical end to private bids for public companies. These tests would probably underestimate spillover effects, but the information gleaned from them could help regulators estimate these effects and consider mitigating action.
Second, regulation should be targeted at highly leveraged institutions with short-term funding, whatever their legal status, is an important step toward a comprehensive regulatory framework. Many years ago, the only significant highly leveraged institutions were commercial banks. Today, leverage is a characteristic of companies throughout the financial system. It is this leverage?when coupled with short-term funding liquidity?that threatens market gridlock in a disintermediated financial system. We need to switch the attention of the regulators, at home as well as abroad, from an institutionally defined approach to a functionally defined approach. Institutions are not born with original sin or original virtue; it is their behaviour that can have potentially damaging systemic implications.
Third, as the economic cycle is the major source of systemic risks, capital charges and provisions for bad debt required by regulators should be raised in a boom and relaxed in a slump as argued by Professors Goodhart and Persaud (Financial Times, June 4). There are complicating issues around this proposal, but the point is that counter-cyclical charges should be based as much as possible on systemic phenomena and less on the characteristics of the individual firm.
These three measures are practical steps toward the regulation of systemic risk. If we wish to make the international financial system more stable, the Basel committee and the Financial Stability Forum must shift away from excessive reliance on the New Basel Consensus?greater transparency, more disclosure and more market sensitive risk management at the firm level?and instead develop practical systemic proposals. These measures may also represent the abiding principles that the Reserve Bank and the government should use in considering the next evolution of India?s financial system, an evolution required to support the growth, ingenuity and internationalisation of the Indian economy.
The author is chairman of London-based Intelligence Capital, governor of the London School of Economics and emeritus professor of Gresham College in the UK