23 October 2010

Why Financial Regulatory Reforms Are About to Fail

In the aftermath of the Financial Crisis 2007-2009 financial regulators, governments and international governing bodies are not just sitting and waiting. Lots of the ways to regulate the greedy, too irresponsibly and carelessly behaved financial sector are being discussed and implemented. For example, on July 21, 2010, President Obama signed into law the Wall Street Reform and Consumer Protection Act of 201 (see the White House’s Wall Street Reform Page here or FED announcement here). At its 12 September 2010 meeting, the Group of Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision, announced a substantial strengthening of existing capital requirements and is also introducing the new liquidity requirements (see the announcement here). On 15 September 2010, the European Commission adopted a proposal for a regulation on short selling and certain aspects of Credit Default Swaps (see press release here). With these and other reforms, several new agencies and supervising bodies are being created, and the mandates of the existing ones revised; new co-operation agreements are born. While the most apparent issues at least seem to be addressed, the reforms are still about to fail. Why?

First, the whole thing has gone far too complex and, also thanks to the regulatory reforms, is going even more complex. And I’m not only talking about the innovative instruments like Credit Default Swaps (CDSs), Collateralised Debt Obligations (CDOs) or CDOs-squared or –cubed. I’m even not keeping that much in mind complex financial schemes and structures like all the securitisation and Structured Investment Vehicles (SIVs). Instead, the paradox is that also the arguably simple but big enough retail banks are implementing (and investors and regulators expect them to implement – because of lowering the required capital and the complex environment where they operate respectively) complex models for assessing the risks of their business, for calculating their capital need, for pricing credits to the customers, for measuring their profitability etc. But estimating things like correlations, the size of the possible asset bubble and the true risk level have proven to be very tricky. The new liquidity requirements, countercyclical capital buffers, forward-looking provisioning principle and other “improvements” in the regulations will not make the life easier. It is supposed that the managements and supervisory bodies of the financial institutions are responsible for the implementation and validity of the firm-wide risk measurement and control systems – but how could they possibly confirm the validity of their risk models, if even their risk experts with PhDs are going mad with all the complex formulas and extremely sensitive model parameters? Furthermore, if the firms by themselves don’t actually know their risks, what leads us to think that the supervisors do?

Secondly, there is far too much bureaucracy. It is clear that a lot of supervision is needed for containing such powerful and complex institutions as the current big banks, especially taking into account that the later have clear motivations to circumvent regulations. Furthermore, supervisors need to have sufficient amount of qualified resources to understand all the newly engineered products and their systemic effects, as well as develop regulatory guidelines that would keep pace with the industry practices. Introduction of the new regulatory reforms only adds new supervisory bodies, committees and institutes who all are engaged with the work of designing and enforcing new restrictions to the financial sector, and supervising the fulfilment of all the existing, modified and new rules. Increased need for the co-ordination of all the supervisory activities only adds to the need for public sector resources. As a result, there is a considerable risk that all this ends up in regulators arguing with each other, burdening financial institutions with endless and ever changing reporting requirements and stress testing exercises none of which really adds notable value, and finally, replacing market failure with the regulatory failure. The provocative question here would be: who pays for all that?

Thirdly, finance is on the path of continuing taking away brains from the rest of economy. Why? Well, that should be obvious: it would not be possible to maintain such a complex system and all the needed supervision without talented people.

Fourth, it is prescribed into the current formula that finance shall remain a profitable and a well-paid sector. Otherwise people and capital would escape. Why should sensible people continue to work on complex financial engineering or risk modelling the social value of which no one really understands if they weren’t paid well enough? Why should any sensible fund manager continue to manage the money of pension funds, if he/she could make much more money on his/her own? Capital finds more profitable sectors even much more easily. These are arguments that keep the hands of governments bound (beside the argument, that credit will be more expensive for the customers, of course).

The fifth, sad thing is that despite of all the efforts, the mechanisms of financial crises remain. At best, the next crisis or a few of them will not be as severe as the one we just saw. These mechanisms include but are likely to be not limited to:
* creating debt without creating money e.g. via different kinds of refinancing and debt restructuring activities where interest is added to the principal, as well as a result of the creation and use of highly profitable but fundamentally flawed financial instruments and –structures;
* self reinforcing, first vigorous and then vicious circles that lead the economy and prices far from equilibrium, the typical credit and asset price cycles such as the one that we just saw in the mortgage prices;
* regulatory cycles where we first see tightening of regulations, which at some point will be replaced by the regulation erosion (given all the complexity and bureaucracy, it’s not difficult to imagine the arguments for abandoning regulations and starting to trust market powers more again) and finally ends again up in the bail outs.

To conclude, I believe that the current approach of closing the holes in the current regulatory frameworks is not enough for securing long term financial stability and a financial system that would be for the society. We need rather significant structural changes into the monetary and financial systems. At the same time, it is easy to understand that the challenge is big. We need to find courage for doing what is right rather than what is easy (and more profitable in short run).


  1. Edward C D Ingram12 June 2011 at 06:57

    Two comments:
    Firstly what is known about the Chinese economists concerns on Debt Swaps allegedly valued in some way at around 60 trillion US Dollars?

    What is payable by whom to whom?
    Do most of these transactions cancel or else how could they amount to so much money?
    And when are these payable - they say starting very soon, so watch out!

    Secondly, the problem with the Housing Finance Sector is its structure. There is a conflict between Monetary Policy and the safety of the sector because of what I call dynamic gearing in the level of repayments.

    In theory, when the level of demand in an economy rises as it will upon economic recovery, say by 1% of GDP due to 1% more economic growth, all values and ALL CASH FLOWS (my addition to the usual economist's guideline) should rise by 1%. The same effectively should happen when incomes and prices both rise by 1% without any economic growth: in money terms this is a 1% rise in demand.

    In this way spending patterns within the economy are kept in balance. No jobs are needlessly lost. But low and behold, the Housing Sector and all sectors using the Level Repayments’ System gear up these repayments, up to twelve-fold. A 1% rise in demand results in a 12% rise in the level of payments as interest rates are dragged up by 1% in response. This diverts spending out of consumption and into faster repayments.

    For a 1% rise in interest rates, we get a budget-busting 12% rise in the cost of Mortgages, and a 1% of GDP per GDP of that kind of debt, diversion of resources (spending) out of the economy for later injection when the recipients find out what to do with it. But that goes to other sectors, or at least it forms a different spending pattern, creating new jobs elsewhere when people gear up to the demand. This later reverses when the economic cycle turns around.

    I shall elaborate on this in a new feature article elsewhere on this site.

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