Regulation in finance has always been a delicate topic; the internal players battle for less of it, a synonym of freedom and excess, and the rest of society asks for more of it. The idea that regulating banks would be damaging to the economy is controversial. Similarly to other registered organisations which impact society on a large scale, they need to be closely monitored. The confusion is to which extent. As can be noticed in the last century, the consequences of a lack of supervision and intervention can be disastrous. The line between progressing towards a safer yet prosperous financial industry and an overly restricted environment is subjective and arduous to draw.
In 2008, following a decline unseen since the Great Depression, the finance industry was targeted with regulatory policies. The extraordinary slow and weak economic recovery that followed despite the stimulating procedures put in place have left economists looking for answers.
Prior to 2008, policies were agreed by legislators who had limited knowledge to form their own opinions, preferring not to challenge the banking industry, they followed the narrative. Unsurprisingly, the intentional use of intricate jargon by bankers is a way to protect their environment from advance public understanding. Financial supremacy has reached a point where governments around the world are scared that banks are not only too big to fail but too big to save. The economy globally fails to reach the growth achieved pre-crisis. One can easily see why additional regulations in finance can be too much of a good thing. This article tries to demonstrate that it would be beneficial for the majority to err on the side of caution.
As legislators learn from the three causes of the collapse; conflicts, complacency and complexity, have the regulations enacted since 2008 sacrificed prosperity for financial stability?
The credit boom started in the late 90’s with the Gramm-Leach-Bliley Act repealing the Glass-Steagall Act of 1933 (the 1933 enactment prevented financial institutions from supporting investment banking activities with commercial banking funds). Albeit, regulations were gradually loosened beforehand. A major cause of the crisis is that financial institutions did not stick to the securitisation model of acting as intermediaries between lenders and borrowers, they became investors. Banks deviated from simple activities in search for more profits, on occasions, betting against their own clients’ trades.
In Europe, to address this information asymmetry, the Market in Financial Instruments Directive (MiFID) will be updated to MiFID II, which will be operational as of January 2018. The main aim of MiFID II is to increase consumer protection and transparency in investment services. In the US, the Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into federal law by Barack Obama in 2010, is the most significant and transformative act since the reforms that succeeded the Great Depression. It included, amongst other reforms, a new consumer protection agency, a tighter regulation of credit rating agencies, a switch from trading derivatives over-the-counter (bilateral negotiations) to public exchanges and the Volcker rule. The Volcker rule, named after Paul Volcker, the former chairman of the Federal Reserve, restricts US banks from undertaking certain speculative trades that are not in the benefits of their customers.
An additional conflict of interest arose when credit rating agencies shifted from an investor-pay model to an issuer-pay model in the 1970s. Not being able to keep up with the demand for the rating of burgeoning new securities, the issuer-pay model has been the solution ever since. The conflict emerges between rating structured products truthfully and securing the deals with lucrative fees. Moreover, finance institutions have been accused of bullying agencies to get the suitable ratings.
Today, perhaps the most striking regulatory reference is Basel II, soon to be Basel III, which explicitly allows banks to use credit ratings from approved rating agencies in calculating their net capital reserve; a rather regressing clause. No serious reforms have been put in place to address this issue so far.
Although the desire to implement regulations before the crisis was not popular, it was real. Given the influence of money in politics, the biggest hurdles were often politically related. Alan Greenspan, the former chair of the Federal Reserve from 1987 to 2006, argued for a safer restructuration of Fannie Mae and Freddie Mac in 2004 but was blocked in Congress.
On October 10th 2008, at an IMF meeting, the G7 agreed on socialising all the risks and liabilities of the entire core financial system. In the words of Martin Wolf:
“A private financial system cannot be argued if this is the response to hard times.”
The too big to fail mentality has pushed financiers to act in a reckless manner since the inception of the Deposit Insurance Scheme. Ultimately, the costs end up on the taxpayer. In the United Kingdom, the Financial Conduct Authority (FCA) has installed an accountability regime for banks and insurers. Fear of increased internal surveillance and sanctions will impact corporate culture and performance.
Constraining employees’ risk-taking initiatives will affect profits; in the end, shareholders are the biggest losers of this regulatory change. In a similar way, retail investors face the stability versus profitability proposition too.
The dominating cultural cognition of risk led politicians and the public, in general, to believe that financiers knew what they did. In fact, they had little knowledge of the repercussions that would ensue. Prior to the crisis, finance was evolving steeply with globalisation (flows of currency were more fluid), technology made considerable improvements (i.e. securitisations), yet, the regulating practices lagged behind.
During the crisis, people were taking different views on the outcome of the same cause. However, no voices were raised and no actions were taken collectively. Complacency effectively emerges when the market mechanism does not allow for the transparent pricing of risk. Prior to 2007, banks based their risk assumptions on relatively narrow risk models. To address this shortcoming,
Basel III regulations have modified the way banks measure their credit and market risks, with more comprehensive risks models. It also emphasises the need to rely on judgement and experience in peculiar situations.
Hyman Minsky (1919-1996), a brilliant but long-ignored economist, argued that long periods of economic stability encourage investors to become less risk-averse. Economic actors give less attention to fundamental economic relationships. These herding patterns which support financial contagion are a form of laxity. To address complacency, Basel III pressurise banks to amass counter-cyclical buffers of capital during good times, a practice not previously put in place. This new Basel legislation will dampen fluctuations of reserves and provide a more reliable safety net in various economic cycles.
Experts suggest that the financial system must be regulated using a more prescriptive and targeted approach. Macro-prudential is a topic of current interest; it suggests regulators intervene when they feel an unstable environment. It seems possible in England, where greater power is given to the Bank of England, but in the US and Europe, lobbies and diverging political interests would render the process extremely difficult.
John Kay, the British economist, mentions that we have developed a very large superstructure of secondary market trading which is mainly irrelevant to the principal needs of the real economy. Collateralized Debt Obligations (CDOs); the structured financial products at the heart of the crisis are essential to the functioning of markets and the fluidification of illiquid investments. It is their overexploitation that confused markets and eventually crunched them. In 2010, the Dodd-Frank Act really oppressed creativity and innovation in derivatives products, ultimately reducing their numbers in various markets.
Historically, regulations in Finance were only able to partially prevent events of the same nature happening again. P2P lending, crowd funding, algorithmic trading, challenger banks are relatively new services that became popular post-crisis. No appropriate regulatory framework is currently in place to prevent consequential shocks that would arise from these new practices.
What would more complex regulations bring this time if they are not anticipative? The complication is that apprehensive regulation has the tendency to jeopardise innovation and progress – two universal phenomena driving mankind.
A significant improvement in the regulations that followed the crisis was the change in accounting principles – the switch from ‘Fair Value Accounting’ to International Financial Reporting Standards (IFRS). It removes some of the complexity in measuring the intrinsic value of assets in distressed environments when market prices collapse.
In the US, the Dodd-Frank Act requires a transparency provision, the need for a collateralised agreement on every deal and a mandate to retain records. The limitation is that regulation is applying a one-size-fits-all generic on financial instruments, and it does not apply to diverging products the intended way. In the current environment, an Argentinian corporate bond is treated the same way as a German bund. Dealers have a hard time coming up with bespoke solutions for their clients. Hence, the current liquidity in markets is not what it used to be, risk premiums and friction have increased.
Significantly important banks have colossal structures. Cross-border banking and financial flows have expanded enormously in the past 30 years. Nevertheless, much of the bank supervision remained national. Banks pursued regulatory arbitrage, transferring their risks back and forth between countries. This is now less likely to happen, thanks to the unification and intensification of global financial regulations.
Recently, 28 countries have signed the Basel III agreement, which is an important step towards global stability.
The Foreign Account Tax Compliance Act (FATCA) is a new successful banking regulation targeting tax evasion. FATCA is the exchange of information between banks in tax havens and other countries. For the criminal, it is about weighing the pros and cons. If the rewards of tax evasion are greater than the possible sanctions, it promotes an evasive behaviour. When better regulations arise, one must ask better for whom? In this case, the act was initiated by the US and made possible by leveraging their financial dominance. Clearly, Swiss incorporated banks have little to gain from this newly established act. Still, FATCA could help governments save millions, even billions in taxes rapidly.
Where Are We Now?
Mark Carney, the Bank of England governor, states that Tier-1 capital ratios (ratios that demonstrate the financial strengths of banks based on their core capital) for systemically important financial institutions have more than doubled since 2009.
There are now fewer chances of liquidity runs and government bailouts. Despite the new regulations, some events are practically unforeseeable. The duties of regulators are to mitigate risk not eliminate it. An infallible financial system may not be the most efficient in producing the desired results. Similarly, insuring explicitly against certain risks may actually create more moral hazard. As observed in the past, financial developments will constantly be ahead of the law and banks will find ingenious ways to circumvent the piling regulations.
What is required, above any amount of regulations, is a proactive enforcement of laws, procedures that avoid conflicts of interest and an environment of accountability where offenders pay for their deeds. As one aims for sustainable growth globally, the regulations passed since 2008 reduce the risks of unstable expansions. A total failure of markets is less probable as risks are more isolated. In the end, the safety and interests of the masses are better cared for now than was the case prior to 2008.
Furthermore, unemployment and interest rates are at record lows, while market indices and corporate profits are at record highs. Based on an article published by the Federal Reserve, the combined net income of Citigroup, J.P. Morgan, Goldman Sachs, Bank of America and Morgan Stanley from 2009 to 2014 averaged $41.73bn annually, up from an annual average of $25.08bn between 2002 and 2008. A study from the Centre Of Financial Innovation illustrates that over-regulation is the main current worry in the financial industry, just as it was back in 2006.
Risk management was then rated 10th on the list of concerns. Now it is 11th. For the reasons mentioned above and for the reigning mentality in finance, the regulations enacted since the global financial crisis have not gone too far. Complicated and often unresolved, the new policies improve the public’s welfare and financial safety to a greater extent than they have restricted its prosperity.