Financial Regulation: more focus on growth? : Economic Studies : University of Dundee

Financial Regulation – more focus on Growth

Four themes have come to dominate the debate on financial regulation. The first is the ever-increasing pressure on authorities to balance financial stability objectives with a need to allow, or even encourage, the financial system to help ailing economies. However, this pressure is being applied in a period during which a series of financial scandals and alleged malpractices, largely but not exclusively in the banking sector, have inflamed public discontent with the role and ethics of the financial system. This has led to more calls not only for more effective supervision and punishment, but also for a more fundamental examination of the role of finance in growth and the broader economy, which together constitute the second theme. Third, the desire for a globally coordinated and harmonised approach to implementing new financial regulations is being frustrated by increasing divisiveness in national approaches, resulting on some fronts in serious impediments to progress. This is both because of the practicalities involved, but also because of distinctive domestic agendas which limit cross-border political agreement. The fourth theme is the intractable crisis in Europe, where the faltering and fraught steps towards deeper fiscal union in order to stave off a splintering of the euro have ignited a heated debate over the future structure of the EU’s supervisory framework.

Stability vs. Growth

A staple of regulatory debates in recent years, stability vs. growth has been at the forefront of discussions in the last few months. With difficult fiscal choices needing to be made in many countries and elections looming in some, with little sign of any return to a solid economic outlook the political imperatives to pursue growth oriented policies is mounting. The fear is that we may be “regulating the graveyard”. This problem is at its most acute in Europe – current consensus forecasts see negative growth for the euro area both this year and next, and very little beyond. This is in contrast to expectations for growth of around 2% in the US in 2012/13, and 4%-6% for the emerging world in the same period. The UK is expected to see growth of barely 0.5%-1.0% in the next two years. While the outlook for the emerging world tends to be more sanguine than for the industrialised world, continued sluggish activity in developed economies will inevitably weigh on the rest of the world eventually.

With many governments still saddled by high debt levels, legislators have chosen to place much of the policy response in the hands of central banks, which have pumped huge amounts of liquidity into the financial system. But in the face of limited demand for credit, there is little more central banks can achieve with interest rates already at a low level. A number of central bankers have recently been underscoring this point, fearing that the expectations laid at their door are simply too high. Nonetheless, it seems that the coming weeks and months will see more measures to stimulate growth involving expansions of asset purchase programmes, and in some cases, yet lower interest rates.

The stability vs. growth debate is of course complicated. The argument turns on whether the macroeconomic benefits of averting future crises outweigh the costs of regulations imposed. However, there are structural, cyclical, and regulatory forces in play which means that disentangling the effects of each is extremely difficult. Increased capital requirements for banks may reduce lending, for instance, but there is also a lack of demand for credit in the current climate. It also remains unclear whether we are seeing more permanent structural change in the financial system, for instance a trend towards further disintermediation of the banks, as large corporates increasingly access capital markets directly and engage directly in trade finance. There is still as yet no authoritative account of the aggregate consequences of all the regulatory reforms in train, let alone one which picks apart structural, cyclical and regulatory effects. Cost-benefit analyses, which are in any case extremely sensitive to economic assumptions made, have tended to be limited to individual proposals.

There are instances, however, of regulators and central bankers questioning the interaction of individual rules with other aspects of the economy, such as the ECB’s recently voiced concerns concerning the liquidity coverage ratio (LCR), one of the two new liquidity rules introduced by the Basel III package. The ECB is reportedly arguing for a softening in the provisions of the LCR, because it is concerned that the rules may constrain the ECB’s ability to operate a smooth and effective monetary policy.[1] A number of central bankers have indicated that the huge expansion of central bank balance sheets also affects the assessment of liquidity shortages in the near term. Mr Noyer, who sits on the ECB’s Governing Council, but who is also currently Chair of the Bank for International Settlements, appeared to acknowledge at the end of June both that there are practical issues around the implementation of the LCR, but also that the new rules need to be implemented in a way which takes into account the current set of economic circumstances:

“The new liquidity ratios [...] cannot be applied as they stand as they do not take into account all their consequences and interactions beyond the prudential objectives themselves, which include in particular the functioning of the interbank market, the level of intermediation or the conditions of monetary policy implementation.”[2]Noyer, BIS, 27 June

The Basel Committee is set to discuss alterations to the LCR in terms of the types of assets which will be permitted to be counted in an upcoming meeting, although it appears unlikely that any concrete changes will be proposed at this stage.

Effective Enforcement and Punishment

The pressures coming from the macro-economic environment have coincided with a raft of scandals which have broken over the course of the summer. There are question marks over the behaviour of some elements of the financial system which have inflamed public discontent with financial intermediaries and their employees. Regulators and politicians in some – although by no means all – countries, have come under intense pressure to demonstrate both their ability to effectively police financial activity and to bring offenders to book.

Possibly the most serious of these issues has been the Libor affair. The events concerning Libor call into question not only the efficacy of the process for setting benchmark rates, but also the degree to which such processes may have been open to manipulation by individuals, or susceptible to influence by the authorities. This has the potential to be a long running and costly issue for the banks with further risk of embarrassment for some key players. It is not clear at this stage whether manipulation of benchmarks was limited to Libor or whether it extends to other jurisdictions, and a range of investigations are ongoing beyond the UK. We are likely to see coordinated international work undertaken on benchmarks more broadly, with an emphasis on greater transparency and traded rates. At the very least there will have to be some restoration of confidence in the Libor process, and the investigation into alternatives is ongoing. But given the rapidity with which successive scandals have broken this year, it remains to be seen whether this can be done in a way which restores the public’s faith in the process any time soon.

Beyond Libor, there have been concerns over mis-selling, fees, and sanctions avoidance. These issues will take time to resolve, resulting in continued pressure on financial institutions to demonstrate that they are conducting their business in a way that is deemed ethically and morally suitable. But the succession of scandals begs the question of whether legislation is the answer, given that much of what is at question are behavioural and cultural issues. Some episodes extend beyond rules, and indeed illustrate their limitations.

Away from issues of culture and morals is a debate surrounding what happens when humans are taken out of the equation and replaced with automated, algorithmic and high-frequency trading. A large loss at a prominent US market maker caused by a technological glitch reignited the ongoing debate over market technology, and the SEC is holding a roundtable in September to assess whether regulatory steps are needed.[3] The wider debate around high-frequency trading and whether it is a net benefactor or net malefactor for financial markets is unlikely to die down anytime soon. Further, in the slower-paced retail banking sector, regulators in the UK have asked bank Chairmen to outline their plans to avoid software glitches which led to payment systems problems at some UK retail banks. Costly technological errors will add to concerns about behavioural issues, especially if they lead to consumer or client detriment.

While these discussions continue, a more fundamental debate is taking place. The perception that some financial activity in the developed world has gone beyond that needed for growth or even beyond broader objectives – “socially useless financial intermediation” – has been an important driving force behind the regulatory response to the crisis and also in the ongoing debate about banking structures, and the structure of the financial system more broadly. A recent IMF working paper argued that there is such a thing as “too much finance”, and a paper published by the BIS echoed this theme, arguing that “there comes a point where further enlargement of the financial system can reduce real growth” and that “more finance is definitely not always better.” This, the authors argued, means “there is a pressing need to reassess the relationship of finance and growth in modern economic systems.”[4] A senior regulator in the UK recently called for regulators, politicians, consumer groups and society at large to “honestly debate a crucial trade-off” with respect to the role of banks in the economy,[5] a debate which may be forced and strongly influenced by the recent outbreak of scandals and allegations.

It is important to remember though that for much of the developing world, the focus is more on how to shape their growing financial systems consistent with the need to intermediate rising domestic and international savings flows, albeit in line with stability objectives.

Political Gridlock and Fragmentation of International Implementation

The concentration of several of these scandals in London has of course given the opportunity to other financial centres to try to seize a competitive advantage, and an excuse for a return to domestically focused regulatory policy by some. Regulation, supervision and enforcement appear as much as ever a weapon in the war for competitive advantage between financial centres, which further complicates the debate about a global approach to financial regulation.

Away from Europe, Mexico – which currently chairs the G20 – has announced that its leading banks will comply with the Basel capital rules ahead of schedule in September of this year. Indeed, there are a number of jurisdictions which look set to ‘over comply’ with Basel III, either in terms of stricter requirements, or a more rapid implementation timeline.[6] Elsewhere, India’s central bank has indicated that it will make use of “constrained discretion” when it comes to implementing Basel III, in order to take account of India’s specificities. The RBI is looking at possible deviations from Basel guidance on countercyclical buffers, as well as margining requirements for credit counterparties and OTC derivatives.[7] It is to be expected that national authorities will use such discretion where they do not feel that international standards reflect the realities of their domestic financial system; the key question is just how constrained such discretion really is.

In this vein, the Basel Committee this year extended its monitoring of implementation progress for Basel III from the timeliness of reform to matters of consistency.[8] Consistency is a serious concern in a number of areas, from the transposition of Basel III into national and regional law (such as through CRD IV/CRR in the EU), to reform of OTC derivatives,[9] and the lack of progress in converging accounting standards.[10] No doubt in recognition of this, a recent speech by the Bundesbank’s Mr Dombret perhaps serves as a guide to how policymakers are likely to address the need for continued international cooperation in the face of more national discretion. He stresses that rather than a one-size-fits-all approach, a more fruitful way forward is to pursue “international consistency”:

“I do not think it to be appropriate to apply completely identical rules to every country or region. We must strike the right balance between providing a workable level playing field and at the same time providing sufficient flexibility for the peculiarities of national financial systems. The leitmotif of financial regulation ought to be international consistency, not one-size-fits-all.”[11]Dombret, 16 August

Of course, what constitutes consistency is also open to interpretation, and this is likely to be a theme strongly represented in the regulatory world in the months ahead.

It is not just economic circumstances and national characteristics which have had a high profile over the summer; practical policymaking hurdles have also been important, in some cases illustrating how important entrenched interests can be in the formulation of new policies, raising the question once more about regulatory capture.[12]

In the US, the push by the SEC to usher in new regulations for the powerful money market fund industry has foundered as the SEC Chairman Mary Schapiro has been unable to secure a majority at the Commission to back proposals.[13] We are yet to see whether other regulators, particularly the FSOC, are willing or able to step into the gap or if momentum for change has been irretrievably lost. The SEC has also been involved in what was seen to be a setback for the convergence of international accounting rules, with a publication suggesting that US adoption of IFRS is probably a long way off.[14] The IASB, responsible for IFRS, lamented the “continued uncertainty” around US adoption of IFRS, given the G20’s call for progress on convergence. Uncertainty around the Volcker rule also remains an issue, and we are now in the early stages of a two year “conformance period”, despite the absence of a finalised rule.

Europe

In the very near term, headlines are likely to be dominated by the EU’s plans to manage the euro crisis, as well as an intense debate over the structure of financial supervision in the EU. An early Greek exit from the euro would undoubtedly sideline a lot of issues, but it would also highlight the need for the ECB to establish its key role in limiting contagion from such an event.

We are likely to see more detail of what a deeper banking union might entail in the eurozone or wider EU, as countries look to give ground as a quid pro quo for more fiscal burden sharing. Establishing a fully fledged banking union, either in the eurozone or the wider EU, is a long-term project. However, summer saw the task given a shot of urgency, and the European Commission’s plans are due imminently. The key elements of such a union are broadly held to be: a single supervisor for euro area banks, a single resolution authority, and a region-wide deposit guarantee scheme. Recent reports suggest that the Commission’s proposals will speak largely to the first of these three, with less progress made towards either a resolution authority or a deposit guarantee scheme. But these are all extremely contentious issues, and each raises questions about the relationship between the eurozone and EU27. This is particularly sensitive for the UK, which is home to one of the world’s most important financial centres, but which is of course currently under immense pressure to demonstrate that it can effectively police financial activity within its borders.

Even if the EU can come up with a workable roadmap on the tight schedule it has set itself, the requisite institution building will take years to complete and will no doubt be open to much amendment and adaption, all within the context of a low growth environment. We have seen the concept of the ECB as the single supervisor cast and recast, an issue which is unlikely to be resolved by the Commission’s publication. The scope of ECB supervision, as well as whether it will be involved in direct supervision or in more of an oversight role, perhaps engaging in “quality control”, is an open question at this stage. This is to say nothing of the consequences for the EBA, whose role in a new regime remains unclear. As ever, the Commission’s proposals are the first step of a very long process of negotiations between EU institutions and member states. The issue will intensify debates about the evolution of financial markets in the eurozone in relation to non-eurozone countries, to say nothing of the fiscal implications of deeper banking union.

What to watch for

Aside from the developments already mentioned, the regulatory world remains a hive of activity, with a welter of other initiatives in the pipelines. The various and every-growing number of investigations into Libor and benchmarks will continue, including the UK’s Wheatley Review, while the European Commission has launched a consultation of its own.[15] The UK has also recently launched a Parliamentary Commission into banking standards. The report of the Liikanen High Level Expert Group on possible reforms to the structure of the EU banking sector is due imminently, the content of which is at this stage largely unknown. It seems unlikely that the Liikanen report will propose radical structural change in the current circumstances, with the emphasis more likely on the size and composition of balance sheets. The wider debate on banking structures was reignited more broadly after a series of high-profile comments relating to the merits and drawbacks of Glass-Steagall, and the US House of Representatives Financial Services Committee has invited comment on possible alternatives to the Volcker rule.[16] Deadlines for some initiatives appear to be slipping further, with CRD IV/CRR still not finalised as the implementation date approaches,[17] and negotiations on Solvency II ever-more behind schedule.[18] That is not to mention that the Basel Committee’s Fundamental Review of the Trading Book is ongoing, with the consultation deadline imminent[19]; work on a global Legal Entity Identifier continues apace[20]; EU guidelines relating to ETFs and UCITS are out for consultation[21]; and efforts to extend resolution regimes to cover insurance companies and financial market utilities are ongoing both internationally and nationally[22]; amongst other things.[23]

There are also a number of elections approaching. The highest profile of these is of course the US presidential election, at the heart of which is a discussion about the role of government. While much of the rhetoric around repealing Dodd-Frank and may be overblown,[24] it seems clear that a Romney presidency would see the Act revisited in a substantial way.

One final thought. While all these issues are rumbling along, it is worth noting that there is increasing talk about whether or not vast swathes of the regulatory agenda are fundamentally misconceived, as argued in Mr Haldane’s most recent speech:

“[Complex] rules may cause people to manage the rules, for fear of falling foul of them. They may induce people to act defensively, focussing on the small print at the expense of the bigger picture.

[The] type of regulation developed over recent decades might not just be costly and cumbersome but sub-optimal for crisis control. In financial regulation, less may be more.”[25]Haldane, Bank of England, 31 August

Given the raft of reforms in train, the idea that we are fundamentally on the wrong track might be somewhat unsettling. Although it is not a new idea, to have someone of Mr Haldane’s seniority posing serious questions about the rationale of much of the regulatory reform process may be a signal that we are approaching a tipping point in the debate.