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  4. Making sense of the new rules of financial regulation
About City

Making sense of the new rules of financial regulation

Dr Anastasia Nesvetailova

As the row over the recently announced bank levy and restricted bonus pay continues, questions linger as to what effects the broader set of financial reform measures will have. The answers to these questions ultimately depend upon how the crisis has been diagnosed by regulators and politicians.

Unsurprisingly given the magnitude of the financial collapse and its impact on the credibility of many financial institutions, the global credit crisis has initiated the most radical, at least in tone, discussion about financial reform since the 1930s. Three key areas of new regulatory scope can be identified: the products and techniques of financial innovation; the rewards and profits of the financial sector; and the structure of the banking system per se.

While all three areas of renewed policy focus stem from the recognition that the self-regulating market mechanism of regulation did not deliver, disagreements over specific steps of action originate in political differences over how radical the policy response to the crisis should be, and to what extent the banking and investment model of the late 20th century should be overhauled.

Regulating the products of financial innovation

Both in the EU and in the USA post-crisis reform measures aim to address those areas of financial practice that the pre-crisis regulation had ignored. Major plans here include new controls over credit ratings agencies (such as licensing, registration and widening the competition in the industry); establishing organised exchanges for derivatives trading (in order to make these types of trade standardised and transparent); new restrictions for the previously unregulated hedge fund industry (these include registration and publication of previously uncollected data on positions) and greater scrutiny of offshore financial havens.

If implemented fully and internationally, this set of measures would mark a departure from the principles of light-touch regulation which had been based on the notion that private authority is the most efficient regulator of the market mechanism. At the same time, analysts have already indentified the potentially differential effect of the new regulations on the financial markets. For instance, where hedge funds and private equity firms are concerned, as a result of the new rules, US managers may find the European regulatory environment too restrictive, and some of the hedge fund activity is likely to leave the EU regulatory space for looser regulatory jurisdictions, such as Switzerland. Indeed, this process has already been on the way during the past year.

Disciplining financial industry

The second major area of new regulatory norms is based around the idea of 'reigning in' in the financial excesses of the boom years. The underlying principle here is to reduce the social costs of a financial crisis in the future, and specifically, avoid using taxpayer funds when rescuing financial institutions. To these ends, new rules target the incentive structure in the banking industry. Specifically, various restrictions on bonuses and remunerations across the financial system are being introduced, and a number of proposals for orderly bankruptcy procedures in the banking sector are being institutionalised. In the US, the so-called 'Volcker rule' adopted by the US Senate in 2010 prohibits risky trading unrelated to customers' needs at deposit-insured banks. In both the USA and the EU, new consumer protection agencies are being set up*. Rather controversially, the UK authorities recently played with the possibility of breaking up large banking groups such as Barclays or HSBC, much to the anger of the banking elites.

Reforming the banking system

The third area of reform measures concerns the nature and function of the banking system per se. Here, although the originate and distribute (ORD) model of banking remains at the core of the financial architecture, there have been attempts to introduce new behavioural standards both for the banking industry, and for regulatory institutions. At the level of the banking system, the so-called Basel III accord identifies new and tighter capital, liquidity and leverage ratios for banks (alongside other measures). The focus on systemic risk in the financial system has led regulators to proceed with their earlier, unsuccessful, attempts to formulate a macroprudential framework of financial governance.

In the EU, the renewed focus on the regulation of systemic risk, while according to many critics conceptually under-developed, led to consolidation of regulatory powers in a one single institution, the systemic risk council, headed by ECB president. Made up of the EU's central bankers, the pan-European body will issue warnings and recommendations when it detects major financial danger ahead, and follow up by asking member states to take appropriate steps at the national level. In the US, the new set of regulatory institutions include Financial Stability Oversight Council and a new early resolution authority. The move is designed to prevent a repetition of the aftermath of the Lehman Brothers' collapse.

All three areas of reform proposals fall within the general paradigm of 'fine-tuning' the products, institutions and functions of financial innovation. Although seemingly radical in tone, none of the new measures is set to overhaul the foundations of the contemporary banking industry, where banks act as traders of risk rather than intermediaries between savers and borrowers. While critical of some of the recent products of financial innovation, neither does the new framework challenge the very notion that financial innovation spurs economic prosperity. Most worrying perhaps, the regulatory measures do little to address the 'underworld' of the official banking system: the peculiar financial and juridical space that is inhabited by the shadow banking industry. The latter, according to recently published data, is estimated at around $16 billion ($20 billion in 2008), comprising the so-called 'cash' and 'synthetic' banking sub-systems, exceed the size of the official banking system by $3 billion.**

What effects are ongoing regulatory efforts likely to have on the topography of the global financial system? Considering the space left open for regulatory arbitrage and avoidance internationally, and the vague details concerning the more concrete measures and their implementation, it is likely that the size and nature of global banks will not be affected significantly. Also, given that a large part of banking activity in recent decades has focused on performing risk arbitrage in the financial markets (rather than lending services to the real economy, as noted above) it is unlikely that Basle III rules on capital and liquidity per se will seriously change financial strategies of the banks.

Can the new set of regulatory principles suffice in preventing an outbreak of contagious financial crisis in the future? Most likely not. What is quite possible is that the new regulation of the products of securitisation will limit the market for these assets; perhaps the policy will even succeed in helping diagnose a potential problem at an individual bank in time. However on a global scale, the potential for a systemic financial crisis has not been eradicated; in fact, it was not even minimized.

The fundamental reason for this is that the regulations initiated in light of the credit crunch, as indeed, most earlier attempts at global financial regulation, target only some of the repercussions and specific practices of financial innovation, rather than the structural logic and institutional environment facilitating it. As a result, the regulatory, judicial and financial space that gives rise to various forms of financial innovation remains unaddressed by the current reform plans.

A paradox of the global credit crunch is that on the one hand, it has launched the most radical reform of the world financial regulation since the 1930s. Notwithstanding the critique outlined above, new measures targeting banks' derivatives trade, new restrictions imposed on the credit ratings agencies and new controls on the hedge fund industry would have been inconceivable had the crisis of 2007-09 not exposed the failures of the privately regulated financial system. On the other hand however, the cumulative change that private financial innovation has produced in the world of finance since the 1930s is simply too gigantic to be resolved by a new, however refined, set of policies and rules. Control over the products of this complex process - the largely invisible yet highly significant industry of risk trade- would require a new conceptual approach to understanding systemic risk in finance and banking, and correspondingly, a different understanding of the actual role of 'financial services' in the world political economy.

* In the USA, Consumer Financial Protection Bureau would be set up inside the Federal Reserve, but with complete independence from the central bank; it would tackle "abusive" mis-selling of mortgages, credit cards and other loan products. In the EU, a series of legal changes proposed by the European Commission will enhance the consumer protection (for bank account holders and retail investors) maintained by the existing directives on Deposits Guarantee Schemes and Investor Compensation Schemes.

** Figures reflect estimates for the US. See Pozsar, Z., T. Adrian, A. Ashcraft and H. Boesky, 2010, Shadow Banking, Staff Report No. 458, Federal Reserve Bank of New York, July.