While You Were Away

September 2011

Note to readers: Links and references to key studies mentioned in the text appear at the end of the article.

The deteriorating economic and financial climate over the summer is limiting some appetites for the aggressive application of new regulation. This must be frustrating for those who published the implementation details of several proposals just before they left for their summer holidays. The desire to promote sound and stable financial systems remains at the core of regulators’ and policymakers’ aims. Yet, growing concerns about the ability of financial institutions to provide credit are weighing heavily in some countries, this at a time when economies are floundering, conventional monetary policy measures are near exhaustion and fiscal policy options are limited. Central banks are providing substantial liquidity facilities to the commercial banks, so that the risk of a major liquidity crisis, while possible, remains unlikely. Credit growth requires demand, not just supply.

Some of the cuts in growth forecasts, likely to be mirrored at least in part in the autumn reports of agencies such as the International Monetary Fund (IMF), the Organisation for Economic Cooperation and Development (OECD) and the European Union (EU), may reflect the private sector’s previous over-optimism on the growth rebound. While talk of a double-dip recession could well be overblown, few will be keen to risk slippage in future growth since that makes paying off public sector and sovereign debt much more difficult. We can expect much discussion about finding the right balance between underpinning stability and allowing a fully functional financial system to support credit and growth this autumn.

Such growth fragilities are also a reminder of the limits to the usefulness of bank stress tests. Worst-case scenarios are difficult to predict in rapidly changing economic circumstances; genuine worst-case scenarios can be self-fulfilling in creating a panic, and authorities are loath to predict scenarios that involve their own failures or the failures of their political masters. We have also observed a fascinating trade-off between the dangers of crying wolf and the fact that no one wants to be identified as having missed the next crisis or financial casualty. As a result, the summer has seen plenty of comments and warnings about sources of systemic risk – Exchange Traded Funds, Money Market Funds, or a US government default. We have also seen action on short-selling bans in Europe (but without comprehensive joint international moves), as well as further discussion of the issue of high frequency trading. In febrile, thinly traded summer markets, each of these was sufficient to shake market confidence. In some cases there may be reasons for fundamental concern, but to draw attention to every potential source of instability naturally runs the risk of exacerbating nervousness in financial markets and increasing the risk averse mood.

Another policy initiative which has raised its head again in the last couple of months is some form of financial transaction tax. In the 1970s James Tobin raised the concept of a tax on foreign exchange transactions both to lower unjustified levels of activity and to raise funds which could be dispensed in the emerging world. Over the years, various forms of such a tax have been mooted. The current European debate revolves around the question of who bears to costs of financial mishaps as well as deterring activity in some markets. There is very little sign that such a tax will receive international agreement. Nevertheless, some European governments persist in pursuing this notion, presumably on the grounds that they feel it carries favour with the public at a time when the taxpayer is being asked again to foot the bill for sovereign funding.

Implementation Difficulties: National Discretion

At the same time as the overall economic environment has been deteriorating, difficulties in negotiating the implementation of regulation have become apparent in both the US and Europe. As we suggested in last summer’s article ( see here), the tradeoffs between domestic issues and international convergence have tended toward domestic solutions as time and distance from the financial crisis lengthen. Over the summer we had the details of the European Union’s Capital Requirements Directive IV (CRD IV), the Financial Stability Board (FSB) papers as well as consultations dealing with Systemically Important Financial Institutions (SIFIs), on resolution mechanisms and the ongoing progress of the US Dodd-Frank legislation.

Essentially the EU’s CRD IV differs from the Basel III recommendations in two key respects: first, although the proposals are similar on core capital requirements, there are some important differences on definitions. For example, the CRD Tier 1 is not limited to ordinary shares and in some cases insurance capital deductions are allowed. Second, the CRD allows for a much greater element of national discretion in application, including on the implementation of a countercyclical capital buffer. Given that financial systems across Europe are not homogeneous and that the cyclical and structural position of these economies varies considerably, this suggests that it will be many years before there is a consistent approach across the region.

Changes in emphasis between the Basel III recommendations and the EU’s CRD IV are giving rise to strong criticism from the IMF and the Governor of the Bank of England, as well as creating some professional rivalries between US and EU financial institutions.

Moreover, over the summer it became much more apparent how much discretion would be exercised in the practical enforcement of the broad guidelines, once again raising the question of regime arbitrage. The European Banking Authority gave a nod to this issue by calling for “constrained discretion”. In a curious twist, as the details for levying extra capital requirements on systemically important institutions become clearer, a hot debate arose about the merits of being classified as a SIFI. Some institutions felt indeed that being a SIFI could effectively suggest they were ‘too big to fail’ and suggest government support. What is clear is that the worst place to be is at the lowest level of SIFI classification, where the banks assume the cost of the incremental capital charge yet without benefit of the reassurance to its investors that the institution is too big to fail.

The next few months will be critical for demonstrating that regulators and supervisors from different regimes are willing and able to find enough common ground to keep the G20’s objectives on global cooperation on track. Balancing the Basel process with US moves under the Dodd-Frank legislation will be a key challenge, as will finding consistency between Dodd-Frank implementation and EU regulation.

Cross-border Resolution

Part of the unfinished business in the regulatory response is the lack of any workable cross-border mechanisms for the resolution of failing institutions. A number of reports and recommendations have come out in the last couple of months with the Financial Stability Board setting a very tight deadline of early September for its recommendations. However, even if the FSB’s recommendations are accepted – as seem likely – it will be a long time before most frameworks will be in place and there will still be many questions open as to how these mechanism will operate in detail. Much will come down to bilateral discussions between regulators and institutions. Typical issues to be faced in the EU for example are the lack of sufficiently effective insolvency proceedings, the absence in some cases of credible special resolution regimes and, most importantly, the lack of effective cross-border mechanisms.

Europe is struggling with cross-border resolution due to the tough choice still to be made between national legal and resolution mechanisms and the creation of a single European resolution authority, which colours much of their comment. The European Central Bank over the summer referred to some of the more theoretical proposals which have been put forward to implement a new crisis management framework. These include ex-ante legally binding burden sharing rules, a stringent rules-based framework (similar to the US), or even a full-blown European resolution authority, perhaps in concert with European deposit insurance and resolution funds.

Is the UK a ‘Special Case’?

Some countries think they have a much greater significance in the international financial system than their economic clout might suggest. The UK is a good example. Given the particular tack taken by the UK on financial reform, it continues to be at the centre of the debate about regulatory reform and financial archictecture. The Independent Commission on Banking (ICB) is scheduled to deliver its final report on 12 September against the increasingly challenging environment. Moreover, the ICB will also raise questions over competitive forces within the UK and exactly what kind of financial services it is seeking to underpin as a result of its reforms. The latest indications are that the ICB will indeed recommend relatively strong measures to ring-fence retail operations but that the banks will be given a very generous lead in time for the changes. The ICB may also recommend some kind of commission or studies into banking competition and/or small and medium sized enterprises (SME) lending. It is worth noting that, aside from India, no other jurisdiction has contemplated similar moves, and that the proposals have been particularly poorly received by the UK’s European neighbours who have had a long history of universal banking.

The UK authorities have published a number of documents over the summer on the aims and expected operation of their new regulatory structure. They are of international significance given the UK’s critical position in the international network of financial transactions.

Derivatives: A Mixed Bag?

On derivatives, the story is rather mixed. On the one hand, there are a series of delays in both rulemaking and implementation. The EU has postponed the vote on European Markets Infrastructure Regulation (now scheduled for the autumn), and the European Commission has pushed back the deadline for completing the draft rules on the review of the Markets in Financial Instruments Directive (MiFID) to October. US regulation has also seen delays. While there has been some talk of a concomitant delay in Asian derivative regulation (needing the west to set a precedent), the extra-territorial implications of US and EU requirements are a real concern to them. A midsummer CFTC-SEC conference to try to address market concerns on rulemaking was of some comfort, but the intricacies of drafting the body of rulemaking needed to meet SEC and CFTC obligations under the Dodd-Frank bill should not be underestimated. Moreover, both agencies are presently consulting on international swaps regulation, with the intention of studying how different regulatory practices can be harmonised cross-border. In a positive step toward harmonization, the Bank for International Settlements has recently released a joint consultation with International Organization of Securities Commissions (IOSCO) on draft guidelines relating to the trade repository reporting of OTC derivatives. Hopefully, such small and technical efforts at convergence as this and the Dodd-Frank Legal Entity Identifier will help regulators and practitioners make small but continuous progress in the direction of convergence where it most makes sense.

Indeed, regulatory changes in emerging markets may be indicative of the attitude in new G20 members. For instance, China may be considering a new financial regulator to strengthen enforcement in state-owned financial institutions with government-appointed CEOs, which historically outrank the country’s regulators. Beyond this, we have witnessed a raft of regulations, particularly from China which has taken significant steps to adhere to G20 agreements on regulatory reform. In August, we saw its release of draft bank capital regulation, moving far beyond the Basel III minima (by 2.5%), rising yet further for SIFIs. Furthermore, emerging market regulators appear eager to limit risks posed by an unregulated private fund industry. China started the summer by releasing guidelines for the regulation of private funds, followed by India’s proposal in August for mandatory registration of venture capital funds with its regulator, the Securities and Exchange Board of India.

Many of these developments demonstrate that there continues to be tension between the aims of international cooperation and the pressing domestic agendas of a number of countries. While seeking to achieve a unified response, some countries have pressed on with their own plans, sometimes in the hope that these may become models for future implementation.

Looking forward, in the very short term there will be much focus on the UK’s regulatory debate, the reactions to the consultations on dealing with SIFIs and resolution mechanisms for failing institutions and of course the preparations for the run-up to the autumn G20 and IMF meetings. A clear task for policymakers in the coming months will be how to convey the sense that they are both taking the required steps to underpin financial stability as well as doing enough to support economic activity. It is to be expected that the financial industry itself will lose no opportunity to argue about the dangers of over-regulation to the process of financial intermediation. Hence, we should expect plenty of discussion about credit, financial intermediation, growth and stability and possibly another round of estimates of the economic costs of all the proposed new regulations. All of this will feed into the debate about what we mean by macroprudential policy, which tools work and which tools are unlikely to be successful. This debate will be accompanied by ongoing assessments of how new regulatory structures which are being put in place are likely to operate. Beyond this and at a more general level, we should also expect further airing of ideas on financial transactions taxes, checks on commodity trading and perhaps even thoughts on alternative for global currencies.

Many of these developments demonstrate that there continues to be tension between the aims of international cooperation and the pressing domestic agendas of a number of countries. While seeking to achieve a unified response, some countries have pressed on with their own plans, sometimes in the hope that these may become models for future implementation.

It is interesting to note, too, how some of the central bankers, who of course are under pressure to bring even more monetary policy measures to bear to boost growth, are putting the onus back on politicians to deal with questions of budget deficits and fiscal sustainability; we can expect more of this sort of debate. It seems the IMF‘s Global Financial Stability Report will also look at issues such as the impact on banks’ balance sheets from potential sovereign debt losses. And, at a more detailed level, there will of course be the raft of ongoing discussions and consultations on the implementation of initiatives on derivatives, alternative fund management, data collection, infrastructure and market clearing mechanisms, not the least of these being measures to underpin the stability of CCPs and trading depositories. All of these may take a backseat, however, if economies fail to recover from the summer slump in activity.

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