Stalling regulation

Despite widespread agreement three years ago on the need to rein in financial markets with a new regulatory framework, no progress has been achieved.

DONALD KOHN, deputy to former Federal Reserve Chairman Alan Greenspan at the time when the financial crisis broke, has won himself an unexpected and unusual job. He has been appointed to a new committee which has the mandate to guide the United Kingdom (note, not the United States) to financial stability. Speaking to British Members of Parliament at a confirmation hearing, he chose to confess his guilt. According to Financial Times (May 17, 2011), he said: I deeply regret the pain that was caused to millions of people in the U.S. and around the world by the financial crisis.... Most of the blame should be on the private sector: the people that bought and sold those securities, on the credit rating agencies that rated them. But I also agree that the cops weren't on the beat. The regulators were not as alert to the risks as they could have been and, to the extent they saw the risks, were not as forceful in bringing them to the attention of management, or taking actions, as they could have been.

Kohn's honesty contrasts with that of his ex-boss, Alan Greenspan, who, in the past and more recently, has repeatedly chosen to defend the actions of the U.S. Federal Reserve he headed. As far back as early 2008, having noted that the U.S. (housing) bubble was close to median world experience and the evidence that monetary policy added to the bubble is statistically very fragile, he concluded as follows: I do have an ideology.... My view of how the efficiency of global capitalism has evolved over the decades as new evidence has appeared contradicts some earlier judgments and confirms others. I have been surprised by the fierceness of investors in retrenching from risk since August. My view of the range of dispersion of outcomes has been shaken but not my judgment that free competitive markets are the unrivalled way to organise economies. We have tried regulation ranging from heavy to central planning. None meaningfully worked. Do we wish to retest the evidence? ( Financial Times, March 16 and April 6, 2008).

That arrogance in the face of the evidence of either incompetence or complicity on the part of the Fed has only been strengthened in recent times. Barely a couple of months ago ( Financial Times, March 29, 2011) he chose to argue that the authors of the Dodd-Frank Act in the U.S., which was based on the correct perception that much of what occurred in the marketplace leading up to the Lehman Brothers bankruptcy was excess, were wrong in believing that the causes of the crisis could be addressed with the regulatory framework the Act seeks to introduce. This in his view was because the financial system on which Dodd-Frank is being imposed is far more complex than the lawmakers, and even most regulators, apparently contemplate. We will almost certainly end up with a number of regulatory inconsistencies whose consequences cannot be readily anticipated.

Greenspan represents the few seeking to scuttle even the diluted effort, which the Act represents, to regulate markets and prevent systemic failure. He is one among those who have been able to ensure that despite widespread agreement three years ago on the need to rein in financial markets with a new regulatory framework, no significant progress has since been achieved. Even the few steps forward that legislation like the Dodd-Frank Act seeks to take are now being stalled.

Among the arguments being advanced to support the case that the Act is bound to fail if implemented are (i) that it would result in a breakdown of markets even in areas where they serve the economy well; and (ii) that it is impossible to have global consensus on strong regulation, so that efforts to rein in markets in any one country such as the U.S. would merely encourage firms to indulge in regulatory arbitrage and transfer some activities abroad or would shift such activity away from U.S. firms to competing institutions from other countries. In sum, the complexity and, consequent, opaqueness of markets and the fact of global interconnectedness ensure that heavy regulation would merely distort markets and is bound to fail. Many have argued against both these positions with Barney Frank (of Dodd-Frank fame) noting ( Financial Times, April 3, 2011) thus: The assertion that regulators can never get more than a glimpse' of the financial system is self-fulfilling if regulators are not given the mandate or the tools to do so, or if they fail to use the tools they have.

However, the view that it is difficult to strengthen regulation because of the impossibility of achieving global consensus is currently receiving much support. The issue has received attention because the European Union (E.U.), faced with the possibility of either sovereign default or bank failure (or a combination of the two), is under pressure to show that it is instituting regulatory measures that can deal with problems that are all too current. On the other hand, the U.S. has dealt with the problems faced by its financial system (even if not its economy) for the time being. The resulting tardiness in U.S. progress, aided by opposition from economists such as Greenspan, has angered the European Commission because it fears that European players will lose out if it implements some of its plans, including the plan to raise capital adequacy substantially.

E.U. versus U.S.

Reflecting this contradiction is a recent spat between the E.U. and the U.S. over requiring banks to hold more capital in forms that can help cover unforeseen losses in the future but earn less returns today. At the end of May, the European Commissioner in charge of financial markets, Michel Barnier, reportedly wrote ( Financial Times, June 1, 2011) to U.S. Treasury Secretary Tim Geithner demanding that the U.S. toughen the content and quicken the pace of implementation of new banking rules. Citing areas such as capital requirements (where the U.S. is yet to implement fully the older Basel II norms, whereas the E.U. promises to legislate to implement the new Basel III) and limits on bonuses for bank executives, Barnier suggested that the U.S. was falling behind the E.U. because of the latitude it gives banks and the tardy implementation of even diluted rules. The casualty, in his view, was the effort to ensure a global level-playing field.

The U.S. Treasury has, as expected, hit back. It argues that it is the U.S. that is committed to strengthening capital standards, whereas the E.U. is giving banks the freedom to game the system in various ways. It holds that what is important is not the design and scale of executive compensation but whether it encourages risk-taking or not. And it feels that in areas such as the trading of derivatives, it is the E.U. that is behind the U.S. The U.K. too has been subjected to criticism for its proposed light-touch oversight, aimed at protecting the size and profitability of its all-too-import city of London.

At issue also is the proposal being discussed by the Financial Stability Board, consisting of financial regulators from leading economies, to impose an additional capital surcharge on systemically important financial institutions (Sifis) or large interconnected banks. They are to be required to hold top-tier capital (of around 3 per cent in addition to the 7 per cent recommended under Basel III) to cover unforeseen losses. Banks are opposing this on the grounds that it will reduce profits and stifle innovation. But U.S. regulators seem to be backing the move. Daniel Tarullo, one of the Fed governors involved in strengthening financial regulation, has not only backed the case for a surcharge on Sifis but even indicated that it could be significantly higher than 3 per cent. The Dodd-Frank law too requires more stringent capital adequacy norms for large interconnected banks.

However, when markets responded to Tarullo's statement by weakening bank share values, Geithner once again turned his guns on the E.U. and the U.K., arguing that regulators there were undercutting the U.S. effort at strengthening regulation. He said that the U.S. government was committed not only to reducing risk within its own borders but also to minimising the chances that it simply moves to other markets around the world. In a strongly worded statement ( Financial Times, June 6, 2011), he noted: The United Kingdom's experiment in a strategy of light-touch regulation to attract business to London away from New York and Frankfurt ended tragically. That should be a cautionary note for other countries deciding whether to try to take advantage of the rise in standards in the United States.

However, the strident tone was partly aimed at defending dilution of Tarullo's proposal on the grounds that the surcharge imposed on Sifis need not be excessive. Thus, since global consensus is difficult to achieve in a world of differentially placed economies, attention to the presumed loss of competitiveness due to regulatory arbitrage only strengthens people like Greenspan who argue against the toughening of regulation.

If regulation to help prevent future crises of the kind experienced three years ago has to go forward, the emphasis should be on credible evidence from three areas. The first is that the financial innovation and proliferation that followed financial liberalisation from the 1980s has diverted capital from productive investment to speculation and adversely affected growth in the real economy. There is little evidence even in the advanced economies that it has contributed to growth. The second is that the globalisation of finance has not helped but only damaged global economic coordination and management by worsening global imbalances. And, third, that a less integrated and more fragmented world economy, with differently designed and differentially stringent regulation of finance, may be bad for finance capital and banker bonuses but not for the rest of the economy.

Once this evidence is taken into account, attention can be focussed on the task at hand and an appropriate regulatory framework designed. If it is not, the fear of being undercut by the other will be exploited by those who want to preserve the status quo to scupper the already much delayed effort to rein in finance.