Financial reform and regulation: Progress on G20 agenda

1
Financial reform and regulation Progress on G20
agenda

• Aniket Bhushan
• The North-South Institute

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Outline

• Understanding financial market failure and crisis
  
• Principles underlying reform regulatory change
• Key reforms, institutions and status
• Conclusions

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• Core reform areas central to the crisis
• Periphery (1) issues related to core crisis
• Periphery (2) issues seen as important, but not
  directly related to crisis (i.e. crisis
  opportunity to affect wider changes)
• If we had this would we have avoided the crisis
  or mitigated impact?

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Understanding financial failure

• Originate-to-distribute model complex
  derivatives, but simple maturity mismatches
• Leverage and deleveraging cycle (Minsky-moment)
• Contagion cycle financial ? real ? political
• Contagion liquidity ? solvency
• Amplifiers
• Endogenous risk (behavioural)
• Counterparty risks
• Off-balance sheet, contingent lines - paradox of
  trust
• Excess reliance on wholesale finance

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Broad principles underlying reform and regulatory
change

• Core (well-accepted)
• Undercapitalized financial system
• Limits of micro-prudential (individual)
  rationality in regulation, supervision
• Limit size, complexity, in some cases
  interconnectivity of financial inst.
• Mother-in-law theory of risk allocation
• Ex-ante incentives (bail-in) vs. ex-post
  (bail-out, levy, taxes)
• Continuous markets (risk pricing, market
  clearing, basic transformation functions
  market-maker of last resort)
• Peripheral (debated, less accepted)
• Economics vs. finance paradigm scarce liquidity
  vs. price discontinuity
• Limits of fundamentalist efficient-markets
  paradigm (friction, noise, momentum, info
  asymmetry)
• Monetary system (different from financial) broken

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Principles and outcomes

• Outcomes 150 specific G20 commitments,
  unprecedented at global level
• Financial re-regulation (leverage, capital, new
  tools)
• TBTF measures limits
• State/authorities as risk absorber of last resort
  (fiscal costs)
• Ifs and Buts
• Immense coordination, practical implementation
  challenges
• No real broad re-think, within finance-centric
  paradigm, no clear alt/challenge
• Superficial allusions socially
  optimal/responsible financial system finance
  and econ development, sustainable growth almost
  no link with poverty reduction

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Fiscal Cost
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Reforms, institutions, status Core

• Basel III, BCBS, CGFS, CBRG
• Capital standards, common definition (Tier 1),
  higher standards (e.g. TCE). Adequacy ratio min
  capital requirements
• High quality cap (common equity) very low bar (2
  of risk-w-a)
• New LCR (liq. Coverage ratio), NSFR (net stable
  funding ratio)
• CE and Retained Earning in Tier 1 will rise
• Contingent capital
• New leverage ratio (as backstop)
• New rules on off-balance exposure (higher RW for
  securitization)
• New trading book rules
• Countercyclical buffers and forward looking
  provisioning
• Incentivising centralized counterparties higher
  cap req. for intra-financial sector (Com Payment
  Systems)
• Cross-border bank resolution (CBRG, FSB, IMF-WB)

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Core issues (cont.)

• Progress on new trading book rules (Summer 2009)
• Cap standards, adequacy major consultation paper
  (Dec, 2009) final by Korea Nov 2010(?)
  Implementation aimed by 2012 but could 2014-16
• Limited on others (esp. new tools,
  counter-cyclical buffers)
• Banking push back damaging for recovery (IIF)
• Major coordination challenges (BCBS-FSB)
• Remember global standards are lowest common,
  most countries have higher national (Pillars 1, 2
  and 3)

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Banks already raising capital
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(No Transcript)
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Core issues (cont.)

• Financial Stability Board (FSB)
• Recently expanded (G10 -20) main coordinating
  body (all major national reg. 24 countries, BIS,
  ECB, EC, IMF, WB, OECD, Basel committees, IAIS,
  IASB, IOSCO)
• 12 key Standards for Sound Fin Sys (macro
  transparency, market infra, reg and supervision)

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Core

• FSB coordinated (cont.)
• Coordination, esp TBTF (capital, leverage,
  liquidity, firm structure, cross-border
  resolution, fin infra)
• Compensation consultation published March 2010,
  major differences, implementation review Q2/2011
• Similar IAIS for insurance IOSCO for investor
  risk
• SIFI implementation progress (FSB report Apr
  2010) interim report June 2010 G20, final
  recommendations Nov G20
• IMF/FSB/BIS systemic importance paper Oct 2009,
  progress report by Jun 2010
• FSB Cross-border resolution WG Oct 2010 IMF
  studying legal
• OTC derivatives to central counterparty (CCP)
  CPSS, IOSCO, EC, FSB working group, interim
  policy paper Oct 2010 and early 2011

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Core

• Accounting Standards
• Harmonization of IASB (IFRS) and FASB (US-GAAP)
• Derivatives under IFRS (Euro) make balance-sheets
  much larger than US-GAAP
• EU proposed review of mark-t-market off-balance
  sheet etc.
• Cost and fair value accounting
• Target completion June 2011 (likely much delay)
• Outstanding change in composition of IASB, less
  accounting profession rep

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Core

• Macro prudential oversight and systemic risks
• Covers much of terrain already discussed
• FSB progress report June 2010
• CGFS-FSB key SIFI, systemic leverage, capital,
  OTC derivatives
• IMF/FSB early warning exercise
• Data gaps report Nov 2010
• Systemic liquidity risk BCBS-CGFS (May, 2010)
• Systemic risk insurance sector IAIS (2013)

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Core

• Credit Default Swaps (CDS)
• Buying insurance on neighbour's house and burning
  it?
• Diff perspective most liquid instrument
  (55-60trillion), trading even when everything
  froze
• Not transparent, lot of myths (naked shorts)
  very small no. market makers easy pol. target
• But authorities willingly allowed this market to
  grow without oversight 1tr (2001) -57tr (2008)

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Core

• CDS and other OTC derivatives cont.
• CCP more transparency, price, vol, spread
  disclosures trading limits
• State of play CCPs introduced in US and Europe
  (2009) studies in Canada, China, Japan, Russia,
  S. Africa (expected 2010)
• Reg. arbitrage could emerge as major problem as
  countries very much doing their own thing (FSB)

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Core

• Securitization
• More loan-by-loan info on ABS, more assessment
  time. Principle increase transparency and
  retention requirements
• Eurosystem collateral framework 2010-11
• US SEC rule proposed April 2010
• BoE consultation launch March 2010
• Expect fight as pre-existing securitization
  practices across countries v. diff (e.g. Canada,
  India)
• (Link with cap requirements already described
  see Basel-III)

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Core

• Rating agencies
• US new SEC rules on national CRAs (Sep 2009) EU
  legislation entered into force (Dec 2009) Aus
  took effect (Jan 2010) Korea (2009)
• Either studying or draft bill proposed (2010)
  Canada, Japan, Mexico, S. Africa

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Summary status of core issues
High conceptual clarity High/reasonable prospect (with modifications) High level consensus Capital adequacy capital standards trading book changes leverage ratios liquidity ratios countercyclical buffers
Reasonable conceptual clarity Reasonable prospect (in some jurisdictions more than others) Some consensus Charges on SIFI other macro-prudential systemic risk measures FAT, FSC (IMF) Financial Crisis Responsibility (FCR) fee (Obama-TARP levy 0.15 of LFI liabilities) market stabilization fund (Germany, US) bonus/payroll taxes (UK, France) Resolution plans living wills Volcker-rule
Basic concept, low clarity Uncertain prospects No consensus Cross-border resolution regime- its link with national measures (punitive charges, stability funds) bank-tax/levy FTT/CTT
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Key national/regional developments

• US July 4 bill, sweeping reforms
• New council of regulators to monitor systemic
  risk
• TBTF mid-ground between bankruptcy and bailout
  (funeral plans orderly liquidation). Compromise
  Congress/Senate
• Stabilization and resolution fund
• Volcker separation of prop trading from
  guaranteed inst.
• Limits on market-share, exposure to hedge funds
• Under study (2012) no support Canada, Europe
• OTC CCPs new securitization disclosure GAAP
  harmonization
• Consumer protection agency

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Key national/regional developments

• UK
• FSA closure by 2012 (criticized too narrow
  rule-compliance focus at expense of big picture)
• New powers for BoE Financial Pol. Committee
  Prudential Reg. Authority Consumer Protection
  and Market Conduct
• Euro-zone (EU)
• Most far-reaching reforms -greater centralization
• New E. Systemic Risk Board E. Banking Authority
  E. Securities Market Authority insurance (EIOPA)
• Proposed deadline end-2010, stalled, possible
  2011
• New capital requirement, derivatives directives
  -2011
• Corp gov. remuneration consultation Sep 2010
• Greater role for IMF (Financial Soundness Index)
• EU (passport) vs. UK, US fight over hedge-fund
  reg

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Periphery 1 core related

• Monetary system (link to financial)
• Adjustment of macroeconomic imbalances and
  associated ex-rate adjustment (can G20 deliver
  what G7 did) key whose pace, whose terms
• Emerging E macro stability factors diff
• Containing volatile capital flows and asset
  bubbles
• CB toolkit broader (vindicated) selective
  discretionary cap controls
• Reserve accumulation vindicated
• Alternatives IMF FCL (Colombia, Mexico, Poland)
• CB swaps, regional swaps (C-Mai), repo lines
  (liq. supports)
• Peer review mechanisms FSAP, new FSI

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Periphery 2

• Tax havens (OECD-TIEA)
• Hedge funds Dark capital pools, algo trading
  taxes on financial transactions curb speculation
  CTT
• Pervasive debt-financing tax bias
• Socially productive financial innovation
• Mandated business model (Volcker)
• Inequality as source of financial instability
• New kind of (non-national currency) monetary sys
• Meaningful post-crisis fiscal, monetary
  coordination
• Countercyclical anti-shock financing limit DC/LIC
  contagion
• New financing for development, climate, poverty
  reduction

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Conclusions (caution)

• Perimeter of regulation is political (unison in
  rescue, fragmentation in reform)
• Speed, scale, sweeping nature of reform pol
  pressures pose major coordination challenges
• Stricter reg. will take effect as most G7 under
  fiscal tightening pressure (2011-15)
• Next crisis will emerge from regulatory chaos
  (arbitrage, contradictions), overreach, lack of
  coordination

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Framing interventions

• What does a responsible financial system/sector
  look like?
• If new paradigm, what components?
• Rather than dramatizing Gs consider all are
  grappling with common unknown unknows i.e.
  intervene constructive, coherent, solutions

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What we have endorsed

• Getting definition of financial efficiency right
• From risk-reward to risk-social return
• Cross-border regulation weakest link
• Fin sys. key player in growth with equity
• Protection vs. protectionism
• Do not underestimate imp of systemic integrity
  (trust)
• Broader view of macro stability
• State as risk-absorber of last resort proactive
  reg./oversight, weathered better (Canada,
  Australia, India)
• Monetary adjustment mechanism (cost)
  preservation of purchasing power (capital) vs.
  labor
• Countercyclical financing (global),
  institutionalizing SDR could be part of this, as
  could regional/multi-swaps

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Shameless self-promotion

• Widening Global Governance Building on the G20,
  Aniket Bhushan Diana Tussie, Canadian
  Development Report, 2010
• Policy Responses to Unfettered Finance, NSI, 2009
• Beyond Band-Aid Solutions, NSI, 2009
• Mapping the Market Genome policy brief, Aniket
  Bhushan Richard Bookstaber, 2009
• Lessons from the Economic Crisis, The Mark, Jun
  2010
• Undoing the Washington Consensus, The Mark, Jun
  2009
• Explaining Canadas Resilience to the Crisis
  Securities and Housing Finance, 2010