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.

The social market

When AP was hacked, unwittingly sending out a Tweet that the White House has been attacked and President Obama injured, markets fell. The combination of social media and high frequency trading proved to be particularly potent, wiping approximately $136bn from US markets within 3 minutes. 

In spite of the influence social media carries, the regulation of the various platforms (Twitter, Facebook, Google, etc.) with respect to stock markets is not well established. The American Securities and Exchange Commission (SEC) now allows company information to be transmitted to investors through social media “so long as investors have been alerted about which social media will be used to disseminate such information.”

The SEC has not given guidance on the timing of disclosures or the outlets allowed. Indeed, the ruling does not even stipulate that information should be available on corporate websites in addition to other mediums. The ruling similarly avoids discussion on the timing of the disclosure or the dissemination of information across a number of channels. It is even less well established in the UK, where social media usage is more pervasive.

The lack of clear regulatory direction places an additional onus on investors, analysts and the media. Information must be sought across more channels. To meet this need, specialized research platforms exist offering investors the chance to gain a competitive advantage. Evidence from these platforms, as well as independent academic research suggests there is an advantage to this trading strategy.

Social media disclosure and trading use should be more stringently regulated in order to limit these market inequalities.  In the short term, the inclusion of social media will result in the value of a company better reflected in the market place. Information will be revealed more quickly, and spread faster. In principle, this will lead to increased volatility, with limited liquidity causing additional concern.

As more companies adopt social media channels as a way to engage investors and consumers, the ability for social media to influence the market becomes greater. As research platforms incorporating social media information continue to develop, the likelihood of social information having an impact becomes larger. This suggests regulation is necessary.

However, there is reason to be concerned that regulating social media usage is a type of censorship. The recent SEC ruling developed from a court case brought against the CEO of Netflix for posting material information on his personal Twitter account. If regulators are able to regulate who is able to say what across different platforms, it approaches the infringement of civil liberties.

That being said, it would be better for regulators provide clearer guidance to material disclosures on social media, before further market problems arise. If not, the chance that misinformation to spread through social media, causing a fall in the market and economic turmoil increases. As it currently stands, investors are unaware where and when to look for company information. This adds to market fragility, and is a cause for concern.

Trusting the financial markets

Former Bank of Canada governor, David Doge, said trust “is more than a simple belief in something or someone without supporting evidence. Trust is what develops when a group of people share an understanding that the rules for behaviour governing their system or society work well and make things better for everyone.” 

Unfortunately, this shared understanding of rules and behaviour is seemingly missing in financial services. According to the Edelman trust barometer (2012), a yearly survey monitoring public trust in institutions, only 40% of people trust banks. Trust in the more general “financial institutions” sits only slightly higher at 45%.

Trust is not a unitary concept, however.  There are many forms of trust, and the various forms are malleable. All follow the basic premis that an agent will act in a consumers best interest. But, problems of performance based executive compensation, commission fees and a focus on short-terminism means this is rarely the case. 

A loss of trust in financial services is problematic for several reasons. Trust helps the functioning of the financial system, which positively impacts the real economy. With trust, less effort is expended on “keeping tabs, so systems can run more efficiently,” and transaction costs are reduced.  There is less of a chance of bank runs and capital is allocated more efficiently.

While all three forms of trust can and have been broken in recent history, the most common breach of trust occurs in an agency relationship. An agency relationship is a contract where “one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf, which involves delegating some decision making authority to the agent.”  Unfortunately, “there is a good reason to believe the agent will not always act in the best interest of the principle,” if both parties are utility maximizers.1

Agents in financial firms are particularly well placed to maximize their own utility because of asymmetric information, moral hazard and complexity inherent in the financial system. In fact, financial firms exist, in part, because of asymmetric information. Financial agents, be it investment advisors, fund managers or bankers, are employed to utilize this superior information on behalf of the consumer. Agency relationships are fraught with moral hazard, as the agent is not typically responsible for the costs associated with risk taking. The complexity of the financial system is, in part, is what makes agents able to maximize in this way. Together, these three issues create a severe principal-agent problem.

How can regulators help bring trust back into financial services? You can’t, really. Trust develops slowly but surely over time. But, here are some recommendations to develop and maintain trust into the future.

1. Increase transparency
2. Principles over rules based regulation
3. Increase competition in the financial sector while reducing switching costs (consider portability of account numbers)
4. Only allow certain products that meet risk requirements
5. Criminalise breeches of trust
6. Increase financial literacy

Some of these are already occuring, or at least there are movements in this direction. After LIBOR, for instance, criminal charges are being levied against perpetrators. Think tanks and educational instituitions are attempting to encourage literacy. But, its not enough. 

What to expect from Solvency II

Demos meets with MPs Steve Baker and Matthew Hancock today to discuss Solvency II, new EU legislation providing a unified set of rules for insurance companies operating in the Europe. It aims to increase capital requirements and risk management standards across the EU, making the financial system more secure, increasing capital efficiency and improving the ease of doing business. Solvency II also aims to instill risk awareness into governance, operations and decision-making of the EU insurance and reinsurance businesses. It’s estimated that this will affect over 3,600 companies across 27 countries when this legislation comes into force in 2014. But while this means big changes for the whole sector, it will affect some countries more than others.

Major changes to international financial architecture do not come without costs.  A study by Accenture revealed that 30 per cent of insurance companies surveyed expect the cost of implementation to exceed €26m in the short term. Industry consolidation, another likely result of these regulations, is likely to harm UK consumers in the long run. Solvency II regulations may also negatively impact the revenues of insurance companies operating in the UK, as the new requirements make them less competitive against insurance companies abroad. 

Jackie Hunt, finance director at Standard Life, considers Solvency II changes to be “manageable.” Yet, Ms Hunt has also stated concerns that Solvency II is creating an environment where “European insurers are effectively disadvantaged” compared to those operating out of North America.

Insurers based in the EU may have to apply new regulations to their non-EU operations.  Specifically, the amount of capital required will be increased relative to underwritten risk, altering a company’s operational ability and how the company is able to use its deployable capital. Companies such as Axon, Aegon, Aviva, ING, Allianz and Prudential, which have large operations internationally could reasonably move their business outside the EU if regulations are too demanding. Prudential’s chief executive Tidjane Thiam stated he would consider moving Prudential’s headquarters abroad (probably to Hong Kong) depending on the particulars of Solvency II. Thiam specified that Prudential “wouldn’t be having this debate” without Solvency II. While “supportive in principle” of the regulations, the detrimental impact (including to invest in corporate bonds beyond a five year window) may be too much for the company to continue to head operations in the UK.

Even if insurance companies remain in the UK, the assets they purchase and the products they provide to consumers will be affected. For instance, Solvency II regulations will make Asset Backed Securities (ABS) less attractive. A movement away from ABS, will cause a reduction in market liquidity, and a widening of trading spreads in financial markets. More importantly, Solvency II limits the ability for banks to transfer risk through securitisation. 

While the Solvency II regulations are focused on insurance providers, they may have a spillover affect to pension companies.  Increasing regulation will increase the cost of holding extra capital. It is likely that these costs will be passed onto annuity pricing and force prices up. According to Delloitte, 36 per cent of insurers plan to re-price their products before Solvency II is implemented. Twenty six per cent of life insurance companies and 8 per cent of non-life insurance companies are planning on altering their product mix.

Many worry that Solvency II is stricter towards UK insurers. Over the years, European regulators have developed individually. One of the goals of Solvency II, is to combat these differences and increase coordination among regulators. Unfortunately, continental bodies tend to be more similar in their regulatory practices, as such Solvency II may hit UK companies particularly hard.

These negative effects may cause significant harm to the UK economy generally. According to the Association of British Insurers, the UK insurance industry contributes around £10.4 billion in taxes to the UK government, and employs around 290,000 people in the UK alone. The UK insurance industry is responsible for investments of £1.7 trillion (equivalent to approximately 25 per cent of the UK’s total net worth). 

As Britain continues to move towards isolation from the rest of the EU, any power the UK has is decreasing. Consider, for instance, Cameron’s veto of December 2011 EU treaty. This aligned many European leaders against Britain, leaving them to develop a new accord without input from the UK.  Last December Cameron also clarified that Britain's membership in the EU is based on its own interests.

While Cameron’s December 2011 veto of the EU treaty created a precedent for Britain to say “no” to the EU, many argue that it left the UK with less bargaining power. One industry insider stated that the veto created “a heightened sense of not wanting to do any special favours for the UK.” This creates increasing difficulty for Britain to influence the Solvency II capital regime.

Solvency II means big change, but the sector has yet to decide whether it will be wholly good or bad.  Some of the questions Demos will seek to answer in the APPG on Economics, Money and Banking meeting today are:

Are these potential negatives of Solvency II regulation enough for the UK to take action?

Is Britain focusing too much on potential negatives, and forgetting about the improved risk management and the safety effects of the regulation? (Solvency II aims, after all, to protect policyholders.)

Is Britain failing to protect the individual, choosing instead to protect big business? 

And what will happen to the UK if regulators and companies fail to apply EU law?

The truth about LIBOR

Last week, Barclays was fined £290m for its manipulation of Libor rates. While Barclays was the first bank fined, many have been implicated in the scandal. In an ongoing debate surrounding the trustworthiness of Banks and financial institutions, the recent rate manipulation by several banks provides evidence of a ‘culture of market manipulation’, which many argue exists in big banks. Indeed, this most recent scandal has pushed many over the edge, causing outrage and questions as to whether the financial system has become a ‘sewer of systematically amoral dishonesty.’

Libor is the London Interbank Offered Rate, or in more comprehensible terms, the rate banks charge one another for loans. In essence, it reflects the price a bank pays for money. The rate is calculated daily, based on reports from member banks. Barclays, as well as other institutions, manipulated this by submitting rates lower than the numbers they were actually using. Libor has the capacity to impact over $350tn worth of financial products globally, as it is commonly used as a benchmark rate for several products including home mortgages, corporate loans and interest rates on credit cards.

The manipulation made the banks appear more solvent during a time of crisis, making it look like they were paying less to borrow more and covering up the true level of the bank’s financial distress. Actual costs of the manipulation are yet unknown, but the FSA stated the bank’s actions ‘could have caused serious harm’ to other institutions and individuals.

The £290m fine given to Barclays by regulators in the UK and US is a record amount. RBS is expected to receive a £150m fine. HSBC, Deutsche Bank and Credit Suisse have disclosed they are ‘co-operating with regulators’ requests’, and over 20 banks (of the 40 banks that submit rates) have received subpoenas from regulators. RBS has already let go 10 traders involved in the scandal, and at least a dozen other institutions have fired or suspended employees.

Given a lack of information as to the actual costs, if any, of the scandal, the uproar surrounding the manipulation seems to be more a comment on a lack of confidence in, and a mistrust of, the financial services industry. The manipulation shows the bankers’ callous attitude. E-mails were exchanged promising champagne for the misreporting. That traders did not think they would be caught shows disregard for regulatory bodies and the internal systems of the banks. That they were willing to do it in the first place suggests a disregard for the Libor system.

Politicians and regulators alike have responded strongly. Labour leader Ed Miliband has called for a public inquiry into banking culture and practices and has pushed for a new code of conduct criminalising bankers’ abuse of the system. George Osborne has highlighted the inability of the FSA to prosecute the bankers for manipulating rates.

Yet, most responses seem to ignore the fact that information regarding Libor manipulation was known several years ago. Between 2007 and 2008, Barclays failed to act on three separate internal warnings surrounding false submissions. In 2008, the Wall Street Journal published an article alleging banks were submitting lowered rates influencing Libor downwards. Where was the uproar then? Who knew, and when? This Wednesday, Paul Tucker, deputy governor of the Bank of England, will appear in front of the Treasury Select Committee to answer questions along these lines, specifically regarding a telephone conversation ‘during which the external perceptions of Barclays' Libor submissions were discussed.’

So far, senior executives are not being forced to resign, although they will need to face questioning. Should they be forced to resign? Should they face criminal charges? And looking to the long-term, how can Libor, and indeed the financial system, be reformed so something like this does not happen again?