The Institute of International Finance,  an organisation representing many of the world’s largest banks and other financial companies, has issued a pretty frank mea culpa for the litany of errors of omission and commission perpetrated by its members during the financial boom that turned to bust in August 2007.  The Interim Report of the IIF Committee om Market Best Practice states a large number of home truths and makes a host of useful suggestions about risk management, liquidity managements, compensation of senior bankers and superstars, over-reliance on formal quantitative models etc.

The tone of the report is one of “We know we screwed up, but now we’ve learnt our lesson (really we have!!) and we’ll never do it again; so there is no need to regulate us more severely and intrusively”.

The argument against significantly more stringent regulation and supervision of the financial sector is unconvincing.  After all, this is the same IIF that in  March 2007, well before the illiquidity hit the fan, produced a report on bank liquidity, Principles of Liquidity-Risk Management which contained more than 40 recommendations on liquidity risk management to the financial services industry and to the regulatory authorities.  That report too placed much emphasis on the virtues of self-regulation.

Unfortunately, self-regulation stands in relation to regulation the way self-importance stands in relation to importance and selfrighteousness to righteousness.  It just isn’t the same thing.  Despite the more than forty recommendations, Chuck Prince and his fellow bankers were too busy dancing franctically to the beat of the securitisation money machine to take any notice. 

Banks will never regulate themselves other than cosmetically.  Even if each bank were to agree that it would make collective sense to for each and every bank to observe certain practices and to desist from others, the temptation to defect from the agreement will prove irresistible as soon as the next financial boom starts to purr seductively and the next sure-thing money machine is touted by a new vintage of charlatan quants.

So there needs to be new regulation.  Without going into details, the broad outlines of the new regulatory regime are clear.  It is no longer the case that there is a unique vulnerability and a unique systemic stability role for deposit-taking institutions.  Entities funding themselves in the wholesale markets can be just as vulnerable to a loss of confidence and a ‘run’ as deposit taking institutions.  A wholesale market ’strike’ is just as sure a way of bringing a highly leveraged institution to its knees as a sudden withdrawal of deposits.

What matters is, first, that highly leveraged institutions are inherently vulnerable to the temporary disappearance of either funding liquidity or market liquidity.  As long as their assets have long maturities and are rather illiquid and their liabilities have short maturities, this vulnerability to a liquidity crunch is present, regardless of the details of their funding practices. There is no such thing as a safe highly leveraged institution, regardless of the soundness of its assets if held to maturity.

The second key point is that regulators and central banks have decided, rightly or wrongly, that non-deposit taking financial institutions can be too big and too systemically important to fail, thus putting investment banks and potentially also hedgefunds above a certain size, in the same situation that deposit-taking banks have been in for a long time.  The rescue of Bear Stearns was the most obvious expression of this view, although the 1998 rescue of Long Term Capital Management was an earlier example.  Indeed, Northern Rock fits the non-deposit taking description quite well, with only about a quarter of its funding coming from retail deposits.  It did, of course, experience a run on its deposits after the authorities had guaranteed alternative sources of finance for the wholesale funding that had gone awol.

It you are inherently vulnerable and too big to fail, you must be regulated.

Some admittedly still too general and vague principles that will guide the New Regulatory Regime are the following: 

(1) The same regulations will have to apply to all highly leveraged institutions above a certain minimum size, regardless of what they call themselves, regardless of their organisational form, and regardless of which sector they are notionally located in. All banking sector and shadow banking sector entities whose leverage exceeds a certain threshold value, will be caught by this net. 

Both listed (publicly traded) companies and private, unlisted companies, partnerships and other business arrangements should be covered.  Only the size of the enterprise (as measured by balance sheet, value added, turnover or whatever)  matters. 

To avoid the treasury department of a manufacturing company being turned into a de-facto bank to avoid regulation, is must be the case that leverage and the size of balance sheet, regardless of the sector in which an enterprise is formally registered, that will decide the regulatory status of an enterprise.

Commercial banks, investment banks, hedge funds, other investment funds, private equity funds, sovereign wealth funds would all be subject to the same regulatory regime/principles, although the detailed rules could differ among them depending on the economic nature of the activities they engage in.

(2) Uniform risk-weighted Basel II-type capital adequacy requirements should be applied to all highly leveraged institutions above a certain minimum size (as per (1)).  I would expect that the most leveraged institutions would end up with significantly higher minimum regulatory capital ratios than those characteristic of the internationally operating banks currently subject to Basel II.  Some strenghtening of the capital requirements for banks already subject to them also would seem to be desirable.

(3) These capital adequacy requirements or leverage limits should be varied counter-cyclically.

(4) Risk-weighted liquidity adequacy requirements should be imposed on all highly leveraged institutions above a certain minimum size.  These should be developed in the same way as the capital adequacy requirements of Basel I and II.

(5) These regulatory minimum liquidity ratios should be varied countercyclically.

 (6) Uniform reporting requirements should be imposed on all highly leveraged institutions above a certain minimum size.

(7) Originators of illiquid loans and other illiquid assets should, when such assets are securitised, be required to keep a non-trivial equity or first-loss tranche on their balance sheets.  This strenghtens the incentive for information gathering at the origination stage and for continued monitoring of the ultimate borrower over the life of the loan.

(8) To avoid a repeat of the international regulatory race to the bottom, the greatest possible degree of international cooperation and regulation is necessary.  Finance and financial institutions think and act globally.  Regulation and regulators should also.  Substituting a single EU regulator for 27 national regulators would be an excellent start.  Whether there should be a single FSA-style European regulator for all financial institutions and markets (other than for consumer protection) or whether there should be a single European regulator for each market segment or function is something I am not surre about.  But the lunacy of a single market with 27 national regulators is self-evident.

Given (1), (2), (4) and (6), there will be little if any incentive for creating off-balance sheet vehicles for regulatory arbitrage purposes, and transparency would increase.  Point (7) will limit the excesses of securitisation and the destruction and misplacement of information.  Point (8) speaks for itself.

Self-regulation in the financial sector has been a joke.  It has turned out to be an expensive joke.  Those paying the bill are, unfortunately, not those who were laughing when the joke was told.  It is time to get serious about regulation again.

I have no illusions that regulation along the lines I suggest here will prevent future financial instability and crises.  A decentralised, competitive financial sector will always have periods of boom and bust.  Will the proposed reforms help reduce excesses? Undoubtedly.  Will bankers hate these proposals? Undoubtedly.

April 10th, 2008 in Economics, Ethics, European Union, Financial Markets, Monetary Policy, Politics | Permalink