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.

Choice overload and financial instruments

Financial instruments should be more carefully scrutinized before entering the market. Similarly, risk should be portrayed comprehensibly (and comprehensively) to investors.

If individuals behaved rationally, they would seek to enhance their welfare. They would invest and hold a portfolio of assets that met their allowable risk-return trade offs  and was consistent with investment horizon and needs. Unfortunately, this is rarely the case. Indeed, “behavioural economists and empirical researches have shown that in reality members are not particularly good at handling their retirement savings, either because they lack the necessary cognitive ability to solve the optimization problem, because they have insufficient will power to execute it, or even sometimes because they are overconfident.”

Extrapolating from the above article, one can assume that people are making sub optimal choices in their investments. Additionally, evidence suggests that the number of choices available amplifies these facts and “induce a preference for simpler, rather than less risky, options”.

The most likely candidate to address issues around choice overload, poor comprehension and the resulting obtainment of risky assets is the pubic sector. While private sector companies, such as S&P and Fitch have attempted to create evaluative mechanisms, they have failed. Since the crisis, rating institutions have been critiqued for lack of impartiality. Seemingly, a “cosy” relationship existed between rating agencies and banks during the crisis; “many financial experts believe that overly optimistic assessments by ratings firms were a key factor in creating an overblown market for derivatives and mortgage-backed securities.”

If, however, a public sector entity were able to evaluate instruments, and relay this information to the public, a more robust financial system would result. Less risky assets would be on the market, and comprehension would be improved.

Not only would investors be making better decisions, from better choices, but they would also be happier about it. While particularly cloying, it seems that that the mere “presence of categories, irrespective of their content, positively influences the satisfaction of choosers who are unfamiliar with the choice domain.”

When framed like this, it suggests that presenting choices in a better way – where options are relevant to investment goals, and are not too numerous or complex – will result in a type of self-fulfilling prophecy whereby motivation, learning and well-being are enhanced.

Financial transparency is muddying the regulatory waters

Often spoken of as a (if not the) necessary element in restoring/repairing financial markets, transparency seems to be fundamental to new regulatory frameworks and discussions between key figures. But, what does it really mean? And more importantly, what real impact will it have?

In the UK, the freedom of information act means anyone can request and receive information from government. It creates the "right of access" to information held by public authorities. This includes all e-mails. The result? Key decisions are now no longer made via technology. Discussions are held in person and accountability is limited. Certainly, this is a case where improved transparency has had negative repercussions. Consider this in the context of recent financial cases: with regards to LIBOR, e-mails, text messages and other communications are have been fundamental to our knowledge of the manipulation. Should these not have been available, our understanding would be much more limited.

Transparency, definitionally speaking, means something is clear and easy to perceive or detect; in financial markets (and according to the SEC) transparency means "timely, meaningful and reliable disclosures about a company's financial performance." True transparency, is "not just more data with the unintended consequence of investor overload and an unnecessary reporting burden on companies", but is companies disclosing the right information to investors who are financially literate enough to understand. 

On a person-to-company level, financial statements, while widely available, are frequently misunderstood. On a company-to-national level, new regulations regarding transparency are increasingly difficult for institutions to meet. Last week, the European Commission pushed for tougher disclosure rules in Basel III - forcing banks to publish profits and taxes in every national jurisdiction in an effort to minimize tax avoidance. Credit rating agencies (CRAs) are equally opaque - meant to help people understand financial instruments there is a lack of understanding regarding company ratings and risk. The US government is suing S&P for inflating ratings superficially, suggesting a need for 'transparency' exists in that space as well.  Board governance, short terminism and remuneration are all areas that must, and are, being questioned and altered.

Don't misunderstand me, I am all for the concept of improved transparency and believe it is necessary for the correct functioning of financial markets and economic growth. I am somewhat skeptical, however, of what transparency means, what externalities exist from it and whether we can regulate ethics into the system. 

What we do know is that previous systems do not work (in the context of public security, not necessarily with regards to economic growth). What makes us think these new ones will? 

We must demand from our governments evidentiary support of regulatory criterion. We must also work to improve our understanding of these matters, analyse financial statements, and question public companies.  Primarily, transparency itself must becomes clear.

The city is bleeding bankers

Increasing regulation (perceived to reduce innovation) combined with job insecurity and stricter remuneration structures are causing a brain drain in financial services. Meaning, the best and the brightest are now choosing start-ups, technology and other sectors –the chance to innovate and build business– over banking.

What does this realistically mean for the industry? In the short term, it is unlikely to be meaningful. Banks are consistently in the news cutting jobs, and reducing costs. Simply said, an exodus is apparent. In ten or fifteen years down the road, however, a lack of people will exist to step into executive and strategic positions.

On the other side, many argue there has been too much innovation in financial services. A brain drain, whereby the “creative” use their talents in other industries, and leave more conservative individuals in finance, is welcome.

Yet, we must remember that financial services currently:

• Account for 14.5% of UK economic output
• Offer a combined total of 63bn GBP in tax
• Have a 47.2bn GBP trade surplus; larger than all other net exporting UK export industries

If the industry continues to contract a lack of talent in the future will mean an even greater decline in the economy. We are currently on the cusp of our third recession in four years. If top talent continues to leave finance (or choose to not enter in the first place),  how can we drive growth?

We must consider that the movement of talent to other industries is unlikely to lead to an equivalent gain for the UK economy. Digital Shoreditch, for instance, cannot compare to Silicon Valley. Graduates are frequently choosing to move to other countries, where VC funding and government grants are easier to obtain. Additionally, if talented individuals leave the financial sector, what guarantee is there that those who will remain will act in a more conservative manner? Perhaps we will be left with a group of individuals who are unable to manage risk entirely.

Talent should remain in financial services – an industry where infrastructure is already developed and the UK is a recognized global leader. Policy makers and bank officials must begin to address issues of worker outflow now before it is too late.

Who should regulate our banks?

Mario Draghi, President of the European Central Bank, has suggested that financial stability is a ‘common responsibility in a monetary union’ and ‘ensuring a well-functioning Economic and Monetary Union implies strengthening banking supervision and resolution at European level.’

Yet, member countries of the EU have developed their own regulatory agencies and laws. It’s only recently, since the 2007 crises, that policymakers have attempted to coordinate regulations across financial markets. Unfortunately, many believe a clash still exists between regulations, and regulatory philosophy between the UK and the continent.

There are two narratives when considering UK banking regulation. The first suggests that Anglo Saxon financial centers are not regulated properly. According to this account, the Anglo Saxon model, which rests on deregulated capital markets and corporate governance reforms created by internal managers, led to the 2007 financial crises. As such, further regulation is required.

The second perspective suggests that EU and UK regulations are already fairly coordinated. Philip Whyte, Research Fellow at the Centre for European Reform, suggests that there is a significant overlap in European regulations as the UK typically implements regulations earlier and more stringently than other Eurozone countries. As such, the financial regulations currently being introduced should not impact the City too negatively. CRD4 and Vickers certainly suggest the second perspective has some validity, while the financial crises itself recommends the first interpretation.

Perhaps the solution to global financial stability, as Draghi conveyed, is not just further regulation but a banking union. At last week’s Demos Finance APPG event, Mathew Hancock MP argued that further institutionalisation is required to maintain the Eurozone, including a banking, fiscal, and monetary union. Considering that financial regulations currently being implemented, like Solvency II, seek to coordinate EU regulations, is further synchronisation an absurd idea? 

Many have already spoken in favour of further financial union. André Sapir, member of the European Systematic Risk Board (ESRB) has stated there ‘needs to be some element of a banking union, with common supervision, deposit insurance and resolution regimes’ in order to ‘break the kind of vicious circle between sovereign debt and bank problems that we saw in 2011’. ECB executive board member Jörg Asmussen has similarly argued that without further integration, a system to monitor financial systems will have to be created externally. Christine Lagarde, Managing Director of the International Monetary Fund (IMF), suggests ‘we need more risk-sharing across borders in the banking system… monetary union needs to be supported by stronger financial integration, which our analysis suggests should be in the form of unified supervision, a single bank resolution authority with a common backstop, and a single deposit insurance fund’.

 A banking union will be discussed at the 28-29 June EU summit. Already a draft has been created to turn the Eurozone into a political federation, which will include a European Banking Union under the supervision of the European Central Bank (ECB).

As one could expect, a banking union is an area of contention between the UK and EU. While the UK continues to back elements of EU regulatory changes, West the minster has been hesitant to give up power or support EU bailout funds. Britain is opposed to joining a banking union which would place the City under the authority of ECB. If Cameron vetoes the banking union it may result in a union that excludes the UK. However, if Cameron does sign the treaty, it’s possible that Britain will gain some of the influence lost in December. However, signing could result in British tax payers ‘propping up’ European banks.

In the context of regulatory changes, increasing international integration, and positive sentiment towards banking union, how should UK politicians act? What is necessary for European financial stability, and what role should the UK have in creating this stability?

Demos Finance, which launches today at an afternoon conference with the FT, will be discussing these questions through seminars, discussions and research papers.  Watch this space.