The last weeks of 2009 saw a plethora of papers from international and domestic regulators intent on meeting the timetable set at the last G20 meeting. This has left financial institutions struggling to understand and integrate the various proposals and their implications for their institutions in advance of Quantitative Impact Studies (QIS) planned for the first half of 2010.
While 2009 is probably best seen as the year in which the authorities began to recover their poise in the wake of the events that wracked the financial markets in the course of 2008, 2010 will be the really challenging one. There are four major challenges ahead.
- With the crisis largely behind us, the G20 will have a far more difficult time achieving consensus among countries at very different stages of recovery and financial development.
- On the macroeconomic front, authorities will have to determine how to turn off the tap on extraordinary support measures and contain fiscal deficits without choking off the nascent recovery, while differentiating among economies with very different growth, trade and fiscal positions.
- The G20, regulators and politicians are going to have to navigate between a certain amount of ‘post-crisis denial’ on the part of the financial system, and the popular anger that still wants to see financial institutions and their staff punished.
- The hard graft of trying to ‘right-size’ the regulatory changes to come.
If these four challenges can be met, the efforts undertaken should reduce the chances of another major crisis in the near term, mitigate its effects and make clearer any necessary resolution mechanisms. If they cannot, the likelihood that the next crisis will occur shortly, and be far more painful, must be very high. This article looks at the challenges of the year ahead by highlighting where events of 2009 set the stage for what is to come.
Regulatory Highlights of 2009
After the first policy responses in 2009 to stabilise financial markets and prevent an economic meltdown of epic proportions, for the bulk of the year the focus was on finding a balance between bringing order and calm to the banking system while simultaneously determining the correct regulatory response. The former was critical to re-establishing the normal process of financial intermediation; the latter was key to ensuring that those parts of the financial sector whose growth had outpaced the supervisors’ ability to monitor them could be brought back into line.
Sometimes the two policy objectives appeared to conflict. Specifically, encouraging the banks to rebuild capital ratios often seemed at odds with the stated desire to support economic activity by increasing available bank credit. Brave attempts to examine the root causes and explore changes to the financial architecture systemically rather than to propose ‘knee-jerk’ reactions came from three sources: in Europe we had the landmark de Larosière Report, in the UK the influential FSA Turner Review, and the US Treasury proposals of Timothy Geithner.
By April, in spite of clear G20 signals that there was a broad consensus on the need to act decisively and jointly on a number of fronts, it was becoming clear that coordination of the details was going to be difficult, as differences in approach emerged both within and between countries. The G20 initiatives provided a clear work plan for the future with emphasis on:
- Strengthening transparency and accountability.
- Enhancing sound regulation.
- Promoting integrity in financial markets.
- Reinforcing international cooperation.
- Reforming the international financial institutions.
With immediate effect from April, the G20 created the Financial Stability Board (FSB) from the former Financial Stability Forum, which is now working hard on recommendations ahead of the June 2010 G20 meeting. Membership of both the FSB and the Basel Committee on Banking Supervision was also expanded to include all G20 members, increasing their legitimacy and authority. At about the same time however, further national and regional initiatives began to pour forth in a relatively unsynchronized fashion. As an example, in the UK alone these included: legislation on a new Special Resolution Regime, the Foot Review on offshore financial centres, the Walker Review on UK corporate governance, and the FSA review on liquidity.
For better or worse, political haggling at the national and regional levels and the sad politics of point scoring and scapegoating began to interfere with clear prioritisation of the most pertinent causal issues. This risked compounding the complexity of regulation without reducing the likelihood of future financial crises. In some areas there was a concern that the targets for regulatory wrath were populist ones which had little to do with the genesis of the crisis. Tax havens, hedge and private equity funds have been obvious examples here.
The process of reform was also complicated by the growing resistance from some parts of the financial sector to certain aspects of the proposals on the table. Many banks expressed concern over the ‘unintended consequences’ of the combined effect of changes to capital, leverage and liquidity ratios and how international differences could both dampen intermediation and distort competition. However, the public’s distrust of the banking industry grew as the year wore on, as the proportions of the bailouts became clearer, access to credit remained restricted and, in more recent months, the issue of compensation and bonuses took centre stage.
A number of economies started to stabilise in the third and fourth quarters of 2009, as fiscal and monetary stimulus measures took effect. Much of the emerging world looked increasingly resilient. Many US and UK financial institutions took advantage of the propitious bond and equity market conditions to raise money to rebuild capital bases and repay government bailouts. Many institutions, having taken full advantage of the steep yield curve which had resulted from quantitative easing, announced record half-year profits less than a year after announcing huge losses.
Publicly, European legislators began to put in place the recommendations of the de Larosière Report. This was groundbreaking in that it gave some authority for these bodies to question decisions at the national level, although significant constraints were added to this before its approval at the most recent European finance ministers meeting. Less publicly, financial institutions were all the while working hard to address lacunae within their risk management, technology, control and reporting systems and procedures in an effort to have better real-time understanding of their exposures and better risk management and stress testing.
When we look at the strides made since the crisis began in the late summer of 2007, what is abundantly clear is that it does take a major crisis to jump-start reforms. Whether this momentum can be maintained as markets and economies begin to recover remains to be seen.
The Outlook For 2010
Fissures in regulatory co-operation have been nowhere more apparent than in the treatment of bankers’ bonuses or ‘earn-backs’ proposed by major countries to appease voters and try to use banking revenues to refill emptied treasuries. This is not surprising due to the domestic nature of tax policy and the differing political philosophies among G20 members on this subject. It is nonetheless indicative of the challenges ahead for the G20 this year.
Still, some consensus in objectives is perceptible. Both the US proposal for a levy on wholesale funding and the BCBS proposals for greatly increased correlation charges for counterparty risk seek, in their own ways, to either limit the growth of bank balance sheets with wholesale funds, either with an increased capital charge (BCBS) or by taxing them for their implicit state guarantee (US). Institutions in the US will cry double taxation if they are subject to both the US proposals and those of the BCBS.
The timing of withdrawal of fiscal stimulus and quantitative easing will be closely watched. Small open economies such as Sweden, Israel and Canada are already starting to do this. Getting the pace appropriately adapted to inflationary expectation and growth prospects in the major economies may require closer, more accurate targets than existing instruments permit, meaning risks of missteps must be high. Given the imperative of fiscal tightening in most major economies, policy options will be limited.
Navigating the Scylla and Charybdis of the G20 agenda and domestic politics may be the most challenging aspect of 2010. With mid-term elections in the US and a general election in the UK, politicians will be tempted to play to political populism. This could have dangerous repercussions for fiscal deficit control, appropriate regulatory changes and the ability to encourage the reestablishment of a vibrant financial sector in key major economies, as well as for G20 harmony.
Striking the Right Balance
On the regulatory front, the real work now begins: translating good intentions into regulation, but regulation that strikes a balance between improving systemic stability without completely debilitating the financial institutions concerned and stifling competition and innovation. Based solely on the number of papers on bank regulation spilling out of regulatory websites just before the New Year, there is still a long way to go. These are wish-lists of every possible change, while decision awaits the outcome of impact studies demonstrating their cumulative effect.
There are two significant problems with this approach. First, it is clearly in the banks’ interest to overstate the cumulative effects in the Quantitative Impact Study (QIS) exercise so as to limit the imposition of the changes. Second, there is still an inclination for regulators to respond within the existing regulatory framework, a Basel 2.5, so to speak, rather than to consider whether the existing system is fit for purpose. While this makes some sense as a short-term solution, it does not in the long term. In particular, such a prescriptive regime overloads responsibility on the supervisors. Ideally the onus of the responsibility for demonstrating appropriate business practices, and solid capital and liquidity foundations should be the responsibility of the banks and their shareholders.
Specifically, the drafters succumb to the temptation to address the complexity of banking with ever-more complex formulas for the calculation of risk, when simplification and principles-based regulation is what is called for to address the current opacity of both regulation and reporting. While some readers will understand the intent of the papers, only the most technical will be able to comprehend the actual proposals and their accompanying formulae.
Last of all remains the unfinished agenda – all that has been mentioned over the last 18 months but not yet addressed. This includes both cross-border crisis resolution and ‘living wills’, which must now be translated into harmonisation of crisis procedures and global tools. Efforts to address the early identification of systemic risks – often called macro-prudential regulation, need to move from concept to credible implementation, particularly with an effort to begin to identify the seeds of the next crisis. Another subject yet to be tackled is whether the home country should cover the entire cost of bank rescues regardless of the breadth and scope of those operations and assets around the world.
The agenda is a long and heavy one. Should we overburden the G20 with our expectations, they will be doomed to failure. Realistic objectives need to be set for the G20, and all parties: legislators, regulators, financial institutions and investors, need to propose viable solutions that address the problems without destroying the capacity to finance the economy.
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