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ICFR Regulatory Outlook 2012: Could Domestic Concerns Derail International Regulatory Convergence?

The Macroeconomic and Political Environment: Policy Priorities  

2012 will be dominated by the search for balance between financial stability concerns and the credit growth needs of the global economy. Concerns over the robustness of the global economy and the durability of the eurozone cast doubt over many regulatory proposals. Both Mr Draghi, President of the European Central Bank (ECB) and Mr Enria, Chairman of the European Banking Authority (EBA) have recently warned about the dangers of excessive deleveraging to meet regulatory targets. However, with bank market capitalisations at historic lows and bank funding precarious, squaring this circle will be one of the key challenges of 2012.

National priorities will continue to rise in importance, due to both the practical problems of enacting international proposals and the pressures of election cycles. In 2011, the appetite for aggressive regulatory reform waned, efforts at global coordination faltered, and domestic economic and political issues took precedence as the crisis receded. Ultimately, recognition that the global interconnectedness of the financial system still represented a real threat reinvigorated the G20 agenda on regulatory reform in the autumn, despite mounting concern about economic prospects. Efforts to maintain momentum may struggle this year.

The proliferation of regulatory initiatives made it easy to lose sight of the aims of regulatory reform. In some cases regulatory measures seemed to be driven by populist politics rather than optimal policymaking, particularly in Europe and the United States.  Against the background of the euro crisis, the UK has been engaged in a series of wrangles with its European neighbours over proposals ranging from capital requirements to derivatives legislation and financial transaction taxes. The UK at times seemed to have difficulty balancing its desires to ensure a safer and more stable financial sector (e.g. through imposing stricter than minimum capital requirements) while protecting its financial services sector. The European Commission in turn appeared to be targeting aspects of financial intermediation primarily for their political appeal, rather than for their financial stability consequences. In the United States, Dodd-Frank regulatory initiatives have become key political fodder in the ill-informed mud-slinging between Republicans and Democrats in the run up to the 2012 presidential elections.

Eurozone issues will dominate in the early months of the year as the authorities try to get to grips with sovereign debt sustainability and bank exposure, liquidity and funding. There will be many rounds of summit meetings, but reaching clarity on the European rescue fund and eurozone fiscal integration remains a considerable way off. The latter half of 2011 reminded us of the dangers of investing too much hope in high-level summits. Failure to meet exaggerated expectations for all-encompassing solutions can be counterproductive, with more radical policies having to be adopted later.

A key question is how the recent exercise of the UK’s veto will affect the UK’s ability to shape EU legislation, especially in the crucial area of financial services. In the near term it is unlikely to help the UK to argue its corner effectively.

In the emerging world, policy priorities have differed. This became more evident as 2011 progressed, and will become more pronounced in 2012. Concerns in China and India about slowing growth have led to cuts in leading interest rates, lower reserve requirements and specific measures to lend to distressed sectors. In China, regulators pushed back the deadline for introducing higher capital requirements, and adopted measures to promote short-selling, just as their counterparts in Europe and elsewhere in the developed world have sought to impose bans on such activity. Chinese officials have cited the need to deepen capital markets to aid economic growth, highlighting the significant distance between policy priorities between nations.

Differences in objectives, experience and approach to financial regulation in high growth emerging markets will bolster calls from these countries for a greater voice in the deliberations in the international arena. Without such voice, they may choose to set their own course.

Financial markets have already priced in poor economic prospects, so modestly better or even stable economic data could trigger a New Year relief rally. At the moment consensus forecasts see global growth of around 2.5% this year after some 3% in 2011. However, this masks a split between the emerging world, expected to grow by around 5% this year after 6% last year, and the industrialised world growing barely 1% in 2012 following 1.5% last year. The eurozone is forecast to experience a fall of GDP of at least 1% after some 1.5% growth in 2011, while the US is expected to grow by close to 2% compared to 1.5% last year. Recent signals from the US labour market and signs of a bottoming out of the residential market support this forecast. Investors will need evidence of a more solid recovery to entice them out of cash. Economies are therefore likely to remain very fragile and policy emphasis will continue to lie with central banks.

The Rule-Making Process

The tortuous rule-writing process has led to delays to new regulations in a number of countries. In the US only one quarter of the new rules required by the Dodd-Frank Act have been written to date; others are subject to studies taking place over several years, or otherwise delayed. Funding constraints on regulators and anti-regulation politics by some ahead of this year’s US presidential elections may put the implementation of Dodd-Frank at risk. These issues raise questions about the appropriate relationship between regulators, the regulated industry, and the political system.

The limits of harmonisation are becoming clear. Domestic legal and political constraints as well as different levels of financial development and political philosophies will constrain convergence on rules. Iterative processes taking place in different countries could lead towards convergence in principle, if not to an identity of rules. This may lead to less systemic risk and contagion, to the extent regulatory systems differ. Striking the right balance between genuine national differences and convergence which promotes international systemic stability will be tricky. The ICFR plans to work on the topic of ‘where regulatory convergence matters most’ over the course of 2012.

This is most clearly the case in the EU dispute over the Capital Requirements Directive and Regulation (CRD IV), in which a number of EU institutions are insisting on so-called “maximum harmonisation”, whereas the UK, Sweden, Austria and the Netherlands, as well as non-EU Switzerland, have imposed or are set to impose stricter standards. The Bank of England recently underscored its intention to give the new UK macro-prudential supervisor, the Financial Policy Committee, the tools to conduct as it sees fit countercyclical policy which is consistent with its systemic stability brief. The new European Systemic Risk Board recognises the need for this national autonomy, and has made its views clear. Furthermore, a selection of EU finance ministers has formally recorded their opposition to the maximum harmonisation of capital requirements in an open letter to EU Commissioners Michel Barnier and Olli Rehn. Interestingly, it has also been suggested that imposing higher capital requirements than those outlined in CRD IV may actually enhance the attractiveness of the regime, with tighter rules acting as a sort of stamp of approval or even a guarantee. This begs the question of whether national conduct of macro-prudential policy could simply shift economic problems elsewhere, as US monetary policy is accused of having done in the recent past, and trade and capital restrictions have done historically.

Governance and accountability issues for both supranational regulatory bodies and national or regional macro-prudential regulators and monetary authorities will become important in 2012. Not only will there be increasing pressure from the developing world to make sure that their interests are recognised, but new regulatory structures (such as the Financial Stability Board, The European Systemic Risk Board and the European Supervisory Authorities) will be scrutinised over their performance. Mindful of the fallout of the financial crisis, a growing number of regulators themselves are calling for a clear and open debate about what is expected from them and what they might reasonably be able to deliver.

The Consequences of Regulation in Context

The consequences of recent regulatory reforms are beginning to emerge, including those “unintended consequences” which loom large when new proposals are aired. Even when the broad character of the consequences can be foreseen, it is impossible to know the degree to which they will occur and the specific impact.

One of these is the inevitable shift of activity away from banks and toward “shadow” intermediation, as heavily bank-focused rules provide incentives for other firms to take up their activities. This is perhaps the key issue of the next twelve months: to what extent will the heavier burden on the regulated sector drive activity towards shadow intermediation? The natural questions which follow are: is this good, bad or neutral? and what new risks and fragilities will this create? To the extent that nonbank intermediation creates credit and permits productive investment without creating new systemic risks, the change may be positive. However, under new macro-prudential regimes, the potential risks will be under strong scrutiny, and the regulatory net is likely to be widened in order to capture, measure, and where appropriate, regulate this shadow intermediation. In 2012 we will begin to see how the financial system as a whole will restructure to cope with new costs and opportunities.

Changes to the structure of the financial system itself will be partly a result of new rules relating to the structure of individual institutions, and particularly banking institutions. Sparked by US and UK measures to split or ring-fence banking activities, 2012 is likely to see an intensified debate about financial market fragmentation, as well as the pros and cons of universal banking, and the optimal size and structure of financial institutions. The EU has already launched a study on the structure of banking, and the UK government has committed to accepting the proposals of the Independent Commission on Banking (ICB) in full.

It is frustrating that this debate is taking place before there is any kind of consensus on what the population wants from its financial institutions. Doubts persist that the ICB report is more aimed at minimising the costs to taxpayers of financial failure than it is with stability and competition. Given the differences in domestic banking systems and levels of financial intermediation, together with little evidence of causality between the financial crisis and universal banking, there is unlikely to be broad international support for ring-fencing or splitting up large financial institutions. Indeed, in many emerging economies, the need for capital and weak public debt markets make strong, multipurpose banks a key element in the development of deeper and broader financial systems.

The longer the current economic malaise persists, the more the debate over what we want from our financial system will grow, with greater examination of issues such as competition and consumer protection. As 2012 progresses, we can expect further discussion of the relationship between the financial system and the rest of society. This will likely involve a more open debate about the role and needs of long term investors, whose own interest and role in the crisis seem at times to have been forgotten.

Many regulatory issues still await final rounds of consultation and calibration. Key will be concrete progress on the mechanisms for the resolution of failing cross-border institutions. A complete solution to this problem probably lies many years away, but immediate progress rests on the development of “living wills” for global systemically important financial institutions (SIFIs) by year-end. Closely related to this will be a growing debate over what constitutes a SIFI. Thus far, the focus has been on banking institutions, but with the growth of shadow intermediation and the rising importance of entities such as clearing houses and central counterparties (CCPs), there may be pressure to widen the net. Efforts by firms to define themselves out of the SIFI category by restructurings, as MetLife has recently done in the US, will accelerate in 2012.

All this will matter little, however, if the immediate problem of bank funding is not resolved. The advantages of collateralising derivative and re-purchase agreement transactions have become evident since 2007, as they permit bank creditors to get to the front of any queue in bank insolvencies. Given concerns about bank credit quality, collateralising exposure seemed the smart thing to do at the level of any individual bank. However, while such action on the part of any one bank looks sensible, when all banks begin to do it, other creditors realise they are disadvantaged and refuse to fund on an unsecured basis. This, together with senior unsecured debt being defined as ‘bailinable’ by regulators has given rise to the demand for covered bonds over unsecured bond market funding. Taken to the logical extreme, insufficient high quality, liquid assets remain to protect unsecured creditors, and banks’ ability to extend credit diminishes as their balance sheets shrink. It is not clear what could unblock this logjam, but without a solution, this will be the single largest impediment to credit expansion in 2012.

Legitimacy and Accountability

Governance of supranational regulatory bodies is likely to gain attention in 2012, particularly as a result of the changing dynamics of world trade. But there are other legitimacy issues at stake as well. In the latter half of 2011, there was a growing sense of a crisis which is deeper than financial regulation, and relates to the political and economic system more generally, with ethics and attitudes towards concepts of fairness being discussed more prominently by politicians and the media.

The appropriate relationship between regulators and industry is one particularly important issue for the legitimacy and accountability of financial regulation. It is very difficult to draw the line between legitimate industry input and undue influence. Concerns over the bounds of legitimate lobbying were raised throughout 2011, and this will surely continue in 2012. The notion of regulatory “capture,” whereby regulation comes to be operated in the interests of the regulated industry, rather than in the public interest, is an ever present danger, and the perception that capture has occurred is very damaging to the legitimacy of the whole system. The nature of relationships between politicians and regulators is likely to become a similarly difficult issue in 2012, given the number of high-profile elections across the world, in both advanced and emerging economies. Defending the independence of regulators and supervisors from the electoral cycle is sure to be a prominent issue over the coming twelve months.

2011 was also the year in which movements such as “Occupy Wall Street” gained traction. Such movements were dismissed as lacking in coherence in some quarters, but it seems that questions about unequal access to the benefits of economic growth, and the financing of politics will need to be addressed before these debates quiet down, however much or little coherence they have. In particular, public distaste for what is seen as unwarranted remuneration for the banking and financial sector is likely to remain the longer the economic downturn drags on. We are already seeing government officials and supervisory agencies increasingly discussing the possibility of curbing remuneration through new rules, and we should expect renewed interest in and concentration on topics such as how to assess and ultimately supervise corporate culture. These issues are all related to perceptions that it is not only regulation that needs to change, but also a change in behaviour and ethics, and a reassessment of how best to incentivise financial intermediaries.

Outlook and Conclusion

In sum, we would stress the importance of clarity, transparency, and well defined aims for financial regulation. A lack of well defined aims is bad for accountability, which is bad for legitimacy. In difficult economic times, when popular unrest is on the rise, legitimacy and accountability issues will become more important.

Four years on from the onset of the financial crisis, the objectives of financial regulation are becoming less, not more, clear. In 2011 the regulatory process was buffeted by the macro-economic environment and political processes. In 2012, the macro-economic environment will continue to hang heavy over financial markets, the electoral cycle will assume greater importance as we approach multiple elections, the dynamics of the relationship between regulators and industry will grow in importance, and trends in the structure of financial markets will continue to influence regulatory priorities.

In 2011 we moved into the implementation phase, as many new rules were brought into effect and given substance. But philosophical questions remain, and it is likely that these will get asked more frequently. In 2012 we can expect: more questions about policy priorities, and particularly growth; assessments of new bodies (although on what criteria we will have to wait and see); an increasing focus on shadow intermediation; new initiatives and progress on resolution regimes; a greater strength for emerging market voices; and the possibility of regulators starting a discussion over what is expected from them.

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