Financial Regulation

Mar 29, 2009 Features / Columnists, Ravi Dev

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Last week we initiated the discussion on necessary changes that may be needed in the regulatory and supervisory regimes of our financial system, in light of the demonstrated failures exposed locally and internationally.
As we proceed, we have to guard against repeating the strategic mistake of the French General Maginot after WWI. Reacting to the devastating German sweep into France through their common border, he constructed a massive wall – the Maginot Line – which he asserted now made France impregnable. In WWII however, the Germans, using their newly improved Panzer tanks simply wheeled around the extremities of the wall and overran France – even faster than in WWI.

The reforms that we should embark on should not just hone in on the specificities of the present ingenuity of greedy financiers – these are a constant – but ought to also create a macro environment to minimise the fallout from their inevitable shenanigans onto the real economy.

The last attempt at worldwide banking reform resulted in Basel II. It is not coincidental that countries such as China and India that rebuffed its implementation (unlike Guyana) have held up well. Basel II accepted the “conglomerate universal bank” structure and attempted to model its risks and calculate varying capital ratios to minimize such risks. The approach is inherently flawed because the pertinent risks for such “conglomerates” are “black swan” events – “tail risks” that are exceptionally rare but which can precipitate huge losses – such as CLICO’s Florida investments going bust.

In the 1960s Benoit Mandelbrot had discovered “fat tails” – that very extreme price movements are far more likely than the theories predict. Models that emanated from Modern Portfolio Theory (MPT) all ignored Mandlelbrot’s insight (and the models it spawned) and stipulated that markets fluctuated randomly following a “normal” statistical distribution. The financial wizards – including one at Hand-in-Hand who recently touted MPT – have consistently ignored the historical record: think 1987 and 1997. Basel II will have to go but what replaces it?

Last week we proposed that in Guyana the financial conglomerate structure be abolished since it facilitates regulatory arbitrage into high-risk adventures. The “narrow commercial bank” must replace the “Universal Bank” at the core of our financial system and thus placing a firewall between the former and investment vehicles of whatever name.

Each financial vehicle type – investment/merchant banks, insurance companies, hedge funds, trusts, building societies, broker-dealers, cookshop (if they deal in finances) – must stand alone. Only the commercial banks would be allowed to attract deposits – by whatever name – from the public and from other commercial banks and to transform these into a loan portfolio with a longer maturity.

As we mentioned last week other financial institutions should have to match the maturity of their assets with that of their liabilities. To prevent the endemic situation where financial crises inflict social costs that always dwarf the private costs to the individual financial institution, new regulations have to ensure that, to the greatest possible degree, the latter institutions bear the costs of their failure. Their penchant to revel in the upside on the risks they run, while shifting massive parts of the downside on to society at large, must be constrained.

The specific policy tool has to be capital adequacy requirements. Equity capital can act as a buffer against negative shocks, and hence against the risk of insolvency; it is a tool for curbing excessive risk-taking by bank managers and also might be used to allow supervisory intervention before the onset of bankruptcy.
We therefore recommend that capital adequacy standards must be imposed on all financial service businesses – even the “shadow banking system” – that carry demand liabilities, regardless of size. In addition, effective reserve requirements on deposit-taking banks must also be extended to the other financial institutions. But the regulations must be grounded in what we have belaboured as the rationale for the financial sector: stability in servicing the real economy.

As we have been pointing out, ad nauseum, the Basel II capital requirements are inadequate in several respects, in addition to its reserve requirements being too low – 8% is ridiculous. There is firstly, of course, the acceptance of the banks’ internal models for the determination of asset values: this is akin to putting the cat to watch over the milk. The risk management models’ assumptions are fundamentally flawed as explained above and even such demands it imposed were routinely skirted. Off-balance sheet assets – which hide the riskier investments and reduce the capital requirements – were a favourite ploy and will have to be prohibited.

Basel II recommendations at the individual bank or financial institution level must also be augmented at the systemic level. This is because of the simple logic that as each institution acts in its own best interest, we cannot assume that the totality of their actions will redound to the benefit of the entire system. This is a case of the old fallacy of composition.

Risk, then, can be endogenous – something that Basel II does not confront. Its capital requirement formula tends to be pro cyclical – amplifying leverage movements, permitting expansion in the boom and forcing liquidation in the bust. We have to find a way, obviously at the macro level, to coordinate individual institutions’ actions to a healthy systemic equilibrium. It should be structured to gradually lean against upswings and flex on the downswings. Some have suggested that this might be achieved by linking capital requirements to nominal GDP targets and timing mismatches of maturity between assets and liabilities. .

The secret of effective regulations is not only about the articulation of the regulations: many collapsed states have wonderful constitutions but lousy governance. Success depends on the power and incentives given to the people who have to enforce them: ensure that they are up to speed in knowledge with the people they are scrutinizing and pay then well. There will always be the danger of regulatory capture that will lead to financiers using other people’s money to gamble with.
As Lord Keynes remarked, “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.” We know that to our cost.

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