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Mitigating universal-bank risks

  1. Redesigning Financial Regulation: The Politics of Enforcement by Justin O'Brien -
  2. About This Item
  3. Chapter content
  4. Learning from financial regulation’s mistakes

In order for them to be effective, the proposals must be strengthened with greater mechanisms to ensure that the ECB is adequately accountable for its supervisory decisions. In June , as Spanish authorities desperately negotiated with the European Commission over the terms of an EU bailout for the Spanish banking system, the European Union President, Herman Van Rompuy, issued a paper calling for a European Banking Union that would sever the vicious link between banking crisis and sovereign debt crisis.

Redesigning Financial Regulation: The Politics of Enforcement by Justin O'Brien -

The Van Rompuy paper proposed vast new powers for the European Central Bank ECB to supervise over 6, banks in the eurozone and to establish an EU-wide deposit guarantee scheme, along with creating an EU-wide bank resolution fund that would administer failing banks without imposing direct costs on taxpayers. The German Chancellor Angela Merkel welcomed the proposals as an important step in obtaining German support for allowing the eurozone bailout fund — the European Stability Mechanism — to recapitalise ailing eurozone banks. European Council Ministers then issued a decision supporting the Van Rompuy proposal, and on 12 September the European Commission proposed a regulation that would provide the European Central Bank with banking supervision powers and another regulation to enable the ECB to interact with the European Banking Authority in executing its supervisory powers.

These proposals represent a dramatic institutional restructuring of eurozone and EU banking supervision and will have important implications for the practice of banking supervision in all EU states. They are primarily designed to sever the link between banking fragility and over-indebted sovereigns by authorising the European Stability Mechanism to recapitalise ailing euro area banks on the condition that these banks are subject to strict ECB supervision and conditionality.

The UK government have tentatively supported the proposals, but on the condition that they do not result in limitations on market access for UK banks and financial firms in the eurozone. These sweeping new proposed powers for the ECB raise serious concerns about accountability and institutional capacity to carry out these functions. The EU Treaty establishes in Article a strong form of independence for the ECB in deciding what measures it should use to conduct monetary policy and to achieve its primary objective of price stability.

It is unsurprising therefore why some would advocate that this credibility be extended in the form of banking supervision powers. Nevertheless, it should be pointed out that monetary policy and banking supervision are very different. Monetary policy usually involves the use of a few macro instruments — i. Strong legal guarantees of central bank independence have been considered necessary in fulfilling the price stability mandate. Banking supervision, on the other hand, has a wider number of — often conflicting — objectives: financial stability, investor and depositor protection, consumer protection and tackling financial crime.

Moreover, it is much more difficult to measure whether these objectives have been met and what the economic trade-offs are in achieving them. Also, bank supervisors have the power to restrict and restructure property and contractual rights — belonging to individual firms, depositors, shareholders and creditors — and in doing so to utilise a far greater number of regulatory instruments than is available in monetary policy.

Banking supervision has been subjected to greater accountability mechanisms by allowing, for example, that firms and individuals be consulted before they are subjected to controls and that the content of regulations are clearly ascertainable in advance and proportionate to achieve a legitimate regulatory aim and can be challenged by those subject to them before a fair and impartial tribunal. Unlike monetary policy, banking supervision requires different institutional mechanisms to ensure a more equal balance between the independence and accountability of the bank supervisor.

Most regulators now agree that effective regulation requires a seamless process from crisis prevention through crisis management, but under the proposals the ECB would not be authorised to engage in crisis management, nor would it be permitted to resolve a too-big-to-fail bank, or to use public funds to finance a bank bail-out.

Is it really realistic to give the ECB ex ante responsibilities for micro and macro-prudential supervision while not having the authority to resolve, bail-out, nationalise or unwind a large cross-border bank or to engage in other types of financial rescue?

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In addition, the ECB becoming a bank supervisor might bring it into conflict with its main objective of price stability. According to this view, the ECB might be tempted to lower interest rates or to loosen conditions for bank access to liquidity in order to stabilise the banking sector, but this might lead to easier terms of credit thereby interfering with its price stability objective.

This is particularly problematic given the anticipated broad range of powers that the ECB is expected to exercise as a macro-prudential supervisor that will likely have a direct impact on economic policy. These outstanding issues suggest that continued work on a European Banking Union is needed in order to design a more accountable and effective institutional framework that can better achieve regulatory objectives.

Please read our comments policy before commenting. But the crucial point is that combining the two kinds of institutions extended the protection given to commercial banks to investment banking, artificially reducing its cost of capital. That encouraged the growth of larger, more complex institutions and transferred to taxpayers costs and risks that no one had contemplated. Ignoring this downside would be a mistake, as would peremptory regulation to separate investment and commercial banking.

We need a balanced reappraisal of the advantages and disadvantages of universal banking. Even if there is no justification for untangling commercial- and investment-banking activities, stronger firewalls may be required between them, at least for deposit insurance and government guarantees. Such moves are undoubtedly necessary but should be made cautiously. First, regulation imposes real costs on society.

In particular, prudential regulation creates anticompetitive economies of scale, impairs innovation, adds costs, helps preserve weak management and business models, and passes the pain on to taxpayers if institutions falter. Second, few if any hedge and private-equity funds actually present systemic risk. The unique feature of banks and some of their off-balance-sheet vehicles is that many of their liabilities must be repaid on demand and that any failure to do so has a falling-domino effect.

Virtually all other financial institutions, by contrast, tend to borrow for a specific term or against collateral. If they fail, investors and creditors lose money but not immediate access to cash. For this reason, the same level of supervision and regulation is not appropriate for both categories of institutions. Finally, it is debatable whether regulation actually makes institutions safer or sounder. The current safety-and-soundness regulation of commercial banks has failed.

Proposals for other kinds of institutions must take into account both their different risk profiles and the shortcomings of the way commercial banks are regulated. So far, proposals for managing systemic risk lean toward a more vigilant monitoring of the global financial system and tighter supervision of institutions deemed systemically important. What is also needed is a much better understanding of how systemic risk develops and spreads.

It may well be that risk is caused as much by products as by institutions. Neither the people who designed these products nor their purchasers fully understood them. Yet they poisoned the financial system, spreading silently but virally across the globe, mutating as they went, and reaching system-threatening size without attracting attention.

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Regulators have resisted interfering in the development or dissemination of these products, fearing that doing so would dampen the dynamism of capital markets. Yet much so-called innovation is aimed more at exploiting loopholes and skirting regulation than at meeting the needs of customers.

Products of this kind are unnecessarily—deliberately—complex and opaque. This approach would make products simpler, more standardized, and more transparent, reducing the latent liquidity and counterparty risks that come to the fore in financial crises. By common consent, banks should hold more capital.

How much and in what form are less straightforward questions. More capital makes the industry safer but also lowers returns and, by extension, probably raises prices for customers.

Chapter content

It is critical to balance the need to control risks with the need for attractive returns. Many proposals to strike that balance are encouraging. There is general agreement, for instance, that capital levels should be set counter-cyclically—in other words, institutions should build up higher levels in good times to form a bigger buffer in recessions. There are also ideas to complement the conventional risk-weighted capital targets with limits on leverage assets divided by equity. Two metrics, whatever their individual merits, are better than one, since asking a bank to optimize on a single metric invites unproductive regulatory arbitrage.

Learning from financial regulation’s mistakes

Some proposals to replace the underlying risk models used to calculate capital are a matter of concern. Consultants, academics, and economists have suggested ways to make such models even more sophisticated. The form of capital that banks should hold has been much less debated than the amount. What makes sense for a single bank is harmful for the system. Regulating and supervising banks is difficult. The answer is not just to hire additional regulators and pay them more.

The model of supervision must be rethought fundamentally. Particularly at the height of an economic boom, guidelines are very hard for regulators to enforce. In a system based on rules, the burden would be removed from regulators—for instance, if banks breached capital requirements, a set of previously agreed upon, nonnegotiable escalating responses could be triggered, starting at an earlier stage than they do today. They could include imposing tighter supervision, restricting dividends or bonus payments, or requiring debt-to-equity conversions until proper ratios were restored.

Financial institutions and other public companies now disclose their activities to investors after the fact, in lengthy reports that are neither granular nor synthesized enough to be insightful.

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Regulators have greater access to information about companies than investors do but are even more overwhelmed by complex data. Despite all this disclosure, when market liquidity dried up in late , nobody knew what institutions held which toxic assets. The massive, parallel-processing, and number-crunching power of curious, interested, and directly motivated people around the world would then undertake much of the supervision required.

Neither of these specific ideas may be right, but in the information age the supervision of a vital global industry should not depend on the herculean efforts of a few well-intentioned officials drowning in data and outnumbered and outgunned by profit-seeking bankers. The system can be smarter than that.

Financial markets have outgrown national boundaries and domestic regulatory systems, to the point where no nation can control its own fate. Massive flows take place not only in the well-understood international bond market but also in the interbank, securitization, derivatives, and cross-border-lending markets. For these reasons, global regulation and supervision remain many years away—a reality the G recognized when it refrained from calling for a global regulator. Instead, it proposed the creation of national colleges of supervisors to develop regulatory rules and of a financial stability board, the successor to the Financial Stability Forum FSF , to monitor the global financial system and make recommendations to regulators and national governments.