Tuesday, June 29, 2010

Current thinking in regulatory reform


Author: David Schwartz J.D. CPA David Schwartz J.D. CPA

Regulators have reported the conclusions of study groups looking into the causes of, and remedies for the Credit Crisis. A consensus of opinion exists as to causes, with a growing emphasis among larger central banks on the failings of liquidity risk management. All regulators believe new forms of infrastructure will be needed to prevent a recurrence of the conditions leading up to the Crisis. Larger central banks and securities regulators believe better monitoring within the existing infrastructure must be adopted as a global stopgap until the new infrastructures are created.

ARCHITECTURE OF REFORM

In a clear sign of the public mood, the most respected supervisors are now calling for markets and participants to be restrained. Notably, ECB President Jean-Claude Trichet now believes that the financial sector, which he says “has gradually and quietly decoupled” from the real economy, “can do more harm than good.”

ECB President Trichet: “I am convinced that if banks neglect their primary activity of due diligence, and if they come to abuse risk control techniques, liquidity creation and arbitrage opportunities, finance will do more harm than good to the economy. And crises of the magnitude that we have witnessed become unavoidable.”[1]

Not only has the financial sector decoupled, agrees ECB director Lorenzo Smaghi, it has become far too large when compared to the real economy. It will be necessary to “reduce the incentives for risk taking, the ability of the system to accumulate leverage, and excessive returns in the financial sector.” This will be accomplished through the “interplay of margin requirements, capital requirements and central clearing houses.”

ECB Executive Board Member Smaghi: “When reasonably large, financial markets promote economic efficiency by identifying productive opportunities and transforming savings into the investment necessary to finance those opportunities. However, when they become ‘too large’, relative to what is implied by economic fundamentals, problems like financial complexity, poorly understood financial innovation, herding behaviour, and endogenous risk-taking – to name just a few – suddenly outweigh the benefits. The recent financial and economic crisis is a stark example of that.”[2]

The goal is to limit the motivation of bank employees to take excessive risks by curtailing their compensation. “Compensation should put emphasis on rewarding longer-term business performance.” To restrain risk-taking activities at the bank level, surcharges on capital requirements are being calibrated. These surcharges will force banks to reserve funds for economic downturns and crises, while alerting counterparties to the possibility of excessively risky practices. Market regulators have adopted the term, Macroprudential Policy, to encompass a toolkit of (mainly) capital restraints on those participants whose activities can expose the market infrastructure to systemic breakdowns.   

BIS General Manager Caruana: “The new framework aims to strengthen the resilience of the broader financial system through the identification and mitigation of linkages and common exposures among all financial institutions and across sectors. An example of this approach is the capital surcharge under consideration by the Basel Committee that would be imposed in line with banks’ contributions to systemic risk. ... Perhaps, with sufficiently advanced modeling capabilities, policymakers might link instrument settings to risk indicators that they would aim to keep within an acceptable range, rather as inflation forecasts are used in inflation targeting regimes”[3]

One of the challenges for the macroprudential approach is the absence of econometric research to calibrate the regulators’ proposed models. Toward meeting that goal, GM Caruana has called on researchers “to develop a menu of financial stability-related policy measures that are reliable enough to be commonly accepted.” In addition to enhanced capital and liquidity regulation, Chairman Ben Bernanke of the U.S. Federal Reserve Board called for “an improved information infrastructure.” He cited the Fed’s current efforts “to construct better measures” of counterparty credit risk and links among “systemically critical firms,” to include data on “banks’ trading and securitization exposures, as well as their liquidity risks.” Beyond its modeling efforts, the Fed has also “encouraged the development of industry warehouse utilities for the collection of trade information on derivatives,” which may lead to the disclosure of systemic risk metrics.

FRB Chairman Bernanke: “Both regulation and market discipline have important roles to play in constraining risk-taking in financial markets; the best outcomes are achieved when these two forms of oversight work effectively together. The report recommends a better system of data collection and aggregation to enhance this partnership. Better data collection would enable regulators to more accurately assess and compare risks across firms, markets, and products. A regulatory requirement to track and report timely, consistent, and fully aggregated data on risk exposures could also promote better risk management by the firms themselves. And increased public disclosure of such data would provide investors and analysts with a more complete picture of individual firms’ strengths and vulnerabilities, as well as of potential risks to the system as a whole, thereby facilitating more effective market discipline.”[4]

Trade information can be gathered through central counterparties to “assess the extent to which derivatives trades might concentrate risk or transmit localized or regional shocks throughout the financial system.” Improved infrastructure arrangements are being considered for triparty repo, so as “to improve the stability of this key funding market.”

 

[1] Mr Jean-Claude Trichet, President of the ECB, “What Role for Finance?” 6 May 2010

[2] Mr Lorenzo Bini Smaghi, Executive Board Member of the ECB, Kyoto, 15 April 2010

[3] Mr Jaime Caruana, General Manager BIS, “Macroprudential policy: What we have learned and where we are going,” Madrid, 17 June 2010.

[4] Mr Ben S Bernanke, FRB Chairman, “Remarks on the Squam Lake Report – fixing the financial system,” New York, 16 June, 2010.

Print