Loopholes in financial regulation

Recent regulations such as Basel III and the Dodd Frank Law impose greater capital requirements on banks. Many (including me) believe loopholes exist allowing for the continued existence of systemic risk. Concerns that banks are too big to fail, that the failure of one institution would cause a collapse of the financial system, prevail. To address this concern, the US Federal reserve is considering a further increase of the level of equity capital foreign banks are required to hold. Wholesale funding markets, where banks borrow large sums of money from one another, are also being examined. While these types of microprudential regulations may reduce financial instability, they encourage complacency and limit the capital available on the margins of society.

The development of the shadow banking system, which enables capital markets to provide many of the services previously provided by banks, has both changed the role of banks and reduced the transparency of financial institutions. In turn, this has led to information loss and stickiness. Meaning, less is known about the make up and quality of financial instruments and the terms of financial instruments are more difficult to modify. Together with the increasing interdependence of financial institutions - also a result of the growing shadow banking system - the possibility that the financial system will collapse is increasing.

Regulations attempting to increase bank transparency do not address the capital markets sufficiently and are unlikely to be sufficient in preventing a future crisis. They address neither the resulting difficulty of modifying financial instruments nor the ability of transparency to increase instability through bank runs and price volatility.

Increasing capital requirements on banking institutions, another regulatory tool favoured since the 2008 crisis, address single institutions rather than the financial system as a whole. This may reduce the size of banks, but does not necessarily limit the interdependence of institutions.

To make the financial system more robust, complexity should be reduced. Limiting the length of chains between institutions and ensuring financial instruments are kept simplistic will help. As a result, information would be more readily available and changes to instruments would be easier to implement. [For example, a covered bond, which remains under the auspice of the financial intermediary, is more simplistic instrument than a Collateralised Debt Obligation (CDO) as fewer institutions make up the investment chain.]

Relying on information from external institutions creates risk. Ratings are by their very nature a judgement call. There is no guarantee of accuracy and investors acting upon information from an external agency does not guarantee stability. The reliance on transparency in this form may further information loss; it creates further separation between financial institutions and investors. As such, arguments against limiting complexity due to the sufficiency of transparency are ill advised.

While the type of financial innovation seen in the past crisis may not occur in the exact form again, innovation is unlikely to end. Competition in the pursuit of profits drives financial markets, and instability is an inherent risk. Until macroprudential regulation and oversight are sufficiently implemented to reduce complexity, a great risk still exists.