Dec 29, 2010
Excerpts with footnotes:
4. How internationalised regulation can lead to a new crisis
We are witnessing a movement towards tighter regulation of world financial markets and also towards regulation that is more closely harmonised across the leading industrial economies. That is no accident, as the G20 communiqué pledged that:
“We each agree to ensure our domestic regulatory systems are strong. But we also agree to establish the much greater consistency and systematic cooperation between countries, and the framework of internationally agreed high standards, that a global financial system requires.”Policymakers seem to believe that insufficient regulation, not just ineffective regulation, is to blame for the financial crisis. Moreover, they also want regulations to be more consistent across different countries and intend to further internationalise financial regulation.
However, there are a number of weaknesses, in principle and practice, with the regulations that have been proposed, that might mean they exacerbate future periods of boom and bust.
4.1 Global regulations create global crises
The central argument in favour of supranational regulation is the possibility of financial contagion. Policymakers do not want their own financial systems put at risk by regulatory failures elsewhere. However, with the present crisis emerging in major developed economies, it is hard to justify the sudden focus on the possibility of contagion. Many countries, such as Canada, did maintain stable financial systems despite collapses elsewhere. The contagion from the subprime crisis in the United States was a serious problem only because financial sectors in other major economies had made similar mistakes and become very vulnerable.
To be sure, an economy will suffer if its trading partners get into trouble. There will be a smaller market for their exports, imports might become more expensive or more difficult to get hold of, and supply chains can be disrupted. But that can happen for a range of reasons: a bad harvest, war, internal political strife, a recession not driven by a financial crisis. The financial sector is not unique in that regard.
There is also concern about a “race to the bottom”. As Stephen G. Cecchetti – Economic Adviser and Head of Monetary and Economic Department at the Bank for International Settlements – wrote, it is felt to be necessary to “make sure national authorities are confident that they will not be punished for their openness”.18 Concerns that countries will be punished for proper regulation are overblown. There are powerful network effects in financial services that mean many institutions are located in places like New York, London and Frankfurt despite those locations having high costs. While smaller institutions like hedge funds may move more lightly, big banks and other systemically important institutions need to be located in a major financial centre. At the same time, they do attach some importance to a reliable financial system. Countries are more likely to be punished for bad policy – e.g. the new 50 percent top tax rate in the United Kingdom – than for measures genuinely necessary to ensure financial stability.
At the same time, the coordination of regulatory policies creates new risks and exacerbates crises. Common capital adequacy rules, while increasing transparency, also encourage homogeneity in investment strategy and undertaking of risk, leading to a high concentration of risk. That means that global regulations can be dangerous because they increase the amplitude of global credit cycles. If every country is in phase, systemic risk is higher than in situations where there are offsetting, out of phase, credit booms and busts in individual countries. The situation is akin to a monoculture, a lack of diversity makes the whole crop more vulnerable.
The Basel rules use a similar risk assessment framework across a broad range of institutions which encourages them to hold similar assets and respond in similar ways in a crisis.19 Consequently, instead of increasing diversification of assets and minimising risk, herd behaviour is amplified.20
The recession that followed the financial crisis was undoubtedly sharper because it was global. That meant countries were hit simultaneously by their own crisis and a fall in global demand hurting export industries. There were also more simultaneous pressures on global financial institutions. Global regulations, reducing diversity in investment decisions and behaviour in a crisis, will tend to produce global crises when they go wrong. As a result, internationalising regulations increases the danger to the world economy.
The objective should be to strike a proper balance between standardisation and diversity in regulations. Unfortunately, there are reasons why politicians might go too far in standardising regulations. Politicians in countries with burdensome regulations are tempted to force others into adopting equally burdensome measures, in order to prevent yardstick competition and limit the ability of firms and individuals to vote with their feet. A well known example of this is attempts to curb tax competition by organisations such as the OECD and the European Union. Finally, for some, international summits are more comfortable than messy, democratic domestic politics.
4.2 Macro-prudential regulation and the false promise of Basel III
The economic profession’s understanding of the role of financial regulation is shifting from an insistence on micro-prudential regulation to measures which take into account the systemic risks involved in finance. The new paradigm suggests that a policy approach that tries to make the system safe by making each of the individual financial institutions safe is doomed to fail because of the endogenous nature of risk and because of the interactions between different financial institutions.21
Many of the proposed regulatory changes seem to be inspired – at least in part – by the idea that macro-prudential regulation will require a move away from a regulatory regime that does not take into account the endogenous nature of risk. Unfortunately, the form that the international harmonisation of regimes of financial regulation is taking fails to mitigate excessive leverage in good economic times.
A related question is whether the endogenous nature of risk enables this new regulatory paradigm to succeed at all. Most importantly, caring about systemic risk requires the regulator to identify – explicitly or implicitly – those financial institutions that are systemically important – either individually or in “herds”. Provided that this information can be discovered by the banks or becomes common knowledge, systemically important institutions will know that they will not be allowed to fail. This would create a large moral hazard problem and could represent a key structural flaw that compromises the whole idea of macro-prudential financial regulation.
At the same time, there might be no need for shifting regulations in the macro-prudential direction, especially if the crisis is the result of regulatory and policy failure as set out in Section 1. Policymakers would just need to abstain from policies similar to those that fuelled the boom leading to this crisis. Of course, a greater need for macro-prudential policy and avoiding specific regulatory and policy failure are not mutually exclusive. It is easy to imagine a regulatory environment that combines more attention to the macroeconomic dimension of financial markets; a more prudent monetary policy that becomes contractionary during periods of rapid economic expansions, and sectoral policies that do not encourage asset bubbles.22
However, the regulation of financial markets is taking a path that could exacerbate future booms and busts – in sharp contrast both to the declared intentions of policymakers and to the underlying idea of macro-prudential regulation.
Our criticism of the Basel rules and of the harmonisation of financial regulation needs to be distinguished sharply from the concerns raised by the banking community, which usually point out the costs that would be involved in raising capital adequacy standards. The Institute of International Finance, for instance, has conducted a study of the effects of likely regulatory reform on the broader economy.23 The models used by the study are based on a relatively simple logic. Higher capital ratios require banks to raise more capital, putting an upward pressure on the cost of capital. In turn, this increases lending rates and reduces the aggregate supply of credit to the economy, lowering aggregate employment and GDP.
On that basis, the paper estimates the costs of adopting a full regulatory reform at an average of about 0.6 percentage points of GDP over the period 2011-2015 and an average of about 0.3 percentage points of GDP for the ten year period, 2011-2020. With a different set of assumptions, the Basel Committee estimates the costs to be much smaller. But whether this is a cost worth bearing depends on what the regulatory reform would achieve. If the output gap is a price to pay for an adequate reduction in the likelihood of future crises – and a reduction in the amplitude of business cycles – then it might be worth paying. Unfortunately, the regulatory reform which we are likely to get is unlikely to achieve that.
Firstly, in spite of claims to the contrary, much of the re-regulation simply increases the procyclicality which was characteristic of banking regulation under Basel II. Indeed, Basel III increases the requirements for tier 1 capital to a minimum of 6 percent and the share of common equity to a total of 7.0 percent. And on top of that it introduces a countercyclical buffer of 0-2.5 percent. Yet, that buffer cannot offset the procyclical effect of the increased capital requirements.
We should stress that the problem with Basel III rules is not the absolute size of capital adequacy requirements but the fact that they are based on the borrower’s default risk. Hence, riskier assets need to be backed by a larger capital buffer than less risky ones. During times of crisis, the overall riskiness of extending loans increases and banks will therefore have an incentive to increase the amount of capital which they are holding relative to the total size of their risk-weighted assets. An extreme reaction to economic downturn would thus consist of dumping the riskier assets on the financial market, in the hope of restoring the required capital adequacy ratio, exacerbating the economic downturn and possibly triggering a credit crunch. Conversely, in good economic times, when the measured riskiness of individual loans has decreased, banks will be tempted to hold less capital relative to their other assets and will thus be tempted to fuel a potential lending boom.
A related issue is that current measures of risk – which are used as the basis for the risk-weighted capital adequacy rules – are highly imperfect. In a nutshell, highly-rated assets can be leveraged much more heavily than riskier assets, which is a problem if those ratings are not necessarily accurate. Lending to triple- A-rated sovereigns still carries a risk-weight of zero. As the present fiscal crisis in Europe suggests, exposure to triple-A-rated debt is certainly not risk free. Basel III complements the capital adequacy rules by simple – not risk weighted – leverage ratio limits. However, looking at the past data, there is little reason to believe that these will be effective in preventing future crises. In fact, risk-adjusted and simple balance sheet leverage ratios both show stable bank leverage until the onset of the crisis.24
Similarly, mark-to-market valuation practices are very problematic for assets where markets have become illiquid, and yield valuations that are both very low and uncertain. In times of crisis, this can give rise to serious consequences for companies that report mark-to-market valuations on their balance sheets. For that reason, mark-to-market valuations can exacerbate the effects of economic downturns.
Furthermore, Basel III will contain new, stricter, definitions of common equity, Tier 1 capital and capital at large. In principle, there is nothing wrong with being pickier when selecting the capital assets to use as a buffer when running a bank. It might indeed be prudent to use only common stock and not preferred stock and/or debt-equity hybrids that are permissible under Basel II. However, imposing a common notion of capital on banks and financial institutions worldwide is more likely to make their por tfolios similar and will therefore increase the co-movement existing between their liquidity – or lack thereof – at any given point in time.
A common definition of capital and a similar composition of bank capital across the world will also create incentives for regulators to synchronise monitoring. Such moves are already on their way within the EU – especially in the light of the establishment of common institutions for financial regulation – in spite of the fact that the business cycles in different parts of Europe are not synchronised.
Finally, we should recognise that tighter financial regulation has its unintended consequences. In the past, we have witnessed companies’ moving complex, highly leveraged, instruments off their balance sheets. Much of the financial activity moved – both geographically and sector-wise – to areas which were less heavily regulated. This included moving activities away from the banking industry into, say, hedge funds. And this also includes moving financial activities to jurisdictions that are friendlier to the financial industry. According to the Financial Times25, in the past two years, almost 1,000 hedge fund employees moved from the UK to Swiss cantons, seeking regulatory and fiscal predictability. Insofar as the move towards harmonised financial regulation is imperfect – and so long as there remain jurisdictions and areas of finance that are regulated less heavily – there will be a relocation of financial activities towards these jurisdictions and areas of activity. The corollary is that overly tight regulation can create a situation in which much of the actual financial activity is taking place outside of the government supervision which is intended to curb their alleged excesses.
4.3 Crisis as alibi, symbolic politics
Many of the measures that are part of the G20 agenda are completely irrelevant to any ambition one could possibly have to mitigate systemic risks in the world economy. For instance, the idea that “tax havens” and banking secrecy are among the issues that contributed to the financial crisis is completely unfounded. If anything, tax competition could curb some of the excesses of the big, fiscally irresponsible, welfare states by making it difficult for governments to impose too onerous fiscal burdens on mobile tax bases. It is thus clear that for politicians in high-tax countries, the present crisis has served as an alibi to push forward a variety of measures which they have demonstrated an interest in implementing but lacked a plausible justification.26
In many respects, regulating short-selling is similar. Short-selling cannot be blamed for the financial crisis, just as it cannot be blamed for the Greek debt crisis that occurred earlier this year. Indeed, short-selling is critical in reflecting new, often pessimistic, information about the asset in question into a market price. Enabling European regulators to prohibit short-selling in specific situations – presumably in situations when doubts arise about the ability of a European country to repay its debt obligations – will do nothing to address the underlying problems of fiscal irresponsibility. It is just an illustration of a mentality that pretends that shooting the messenger is an appropriate response to the fiscal problems of the Eurozone. The direct cost of this policy is that it will introduce noise into the functioning of financial markets and will make them process new information less efficiently.
Besides taxation and short-selling, there have been coordinated moves to regulate hedge funds, both in the United States and in Europe. While this might make sense from a macro-prudential perspective, particularly if it is the case that some of the hedge funds are of systemic importance, we should recognise that hedge funds were the victim, not the perpetrator, in the recent crisis. There have been a series of measures that governments have been eager to take for a long time and for which the crisis provided a convenient ad hoc justification, that are now part of the coordinated re-regulation of financial markets in the United States and in Europe. This includes, for instance, the creation of systemic risk boards – as if creation of such institutions would in itself be an improvement over the present situation. Creating a new bureau does not endow the regulators with a superior model of the economy and certainly does not mean that they will be able to do better forecasts than the regulators of the past.
Likewise, the creation of consumer protection boards is unlikely to have a significant effect, besides creating a false sense of security among the general public. After all, the crisis was not caused by uninformed consumers’ falling prey to – say – credit card companies. While instances of individuals making bad decisions regarding their indebtedness certainly exist, they were in most cases a rational response to the wider institutional environment in which they were operating, and which made it worthwhile, for instance, to use one’s house as a piggybank. Furthermore, there is evidence that some of the measures aiming at protecting consumers can in fact exacerbate moral hazard and strengthen the incentives for irresponsible behaviour.27
Finally, the issue of executive pay is high on the list of priorities for policymakers across the globe, again without a credible explanation of how that would contribute to the prevention of future crises. Major proponents of macroprudential regulation – such as the authors of the Geneva report – argue that there is very little reason for regulators to get involved in the decisions of private firms over executive compensation. Rather, as Charles Wyplosz says, “macro-prudential regulation will push banks to develop incentive packages that are more encouraging of longer-term behaviour.”28
18 Cecchetti, S. G. “Financial reform: a progress report.” Remarks prepared for the Westminster Economic Forum, National Institute of Economic and Social Research, 4 October 2010.
19 Eatwell, J. The New International Financial Architecture: Promise or Threat? Cambridge Endowment for Research in Finance, 22 May 2002.
20 Daníelsson, J. & J.-P. Zigrand. What Happens when You Regulate Risk? Evidence from a Simple Equilibrium Model. April 2003.
21 For an exposition of the ideas behind this approach to financial regulation see Hanson, Kashyap and Stein (2010): “A Macroprudential Approach to Financial Regulation.” Journal of Economic Perspectives, forthcoming.
22 In this endeavour, targeting nominal GDP instead of inflation might be instrumental, as Scott Sumner, David Beckworth, George Selgin and others have argued.
23 IIF (2010). Interim Report on the Cumulative Impact on the Global Economy of Proposed Changes in the Banking Regulatory Framework. http://www.ebf-fbe.eu/uploads/10-Interim%20NCI_June2010_Web.pdf
24 See Joint FSF-CGFS Working Group (2009). The role of valuation and leverage in procyclicality. http://www.bis.org/publ/cgfs34.htm
25 FT. “Hedge funds managers seek predictability.” October 1, 2010. Available at: http://www.ft.com/cms/s/0/557f55d4-cd93-11df-9c82-00144feab49a.html
26 Indeed, the OECD has been running its program on harmful tax practices since 1998.
27 We discuss the specific case of the CARD Act in the United States in Rohac, D. (2010). “The high costs of consumer protection.” The Washington Times, September 3, 2010.
28 Wyplosz, C. (2009). “The ICMB-CEPR Geneva Report: ‘The future of financial regulation.’” VoxEU, January 27, 2009. http://www.voxeu.org/index.php?q=node/2872