October 22, 2008
Principles for a new Regulatory Paradigm
(Almost) everyone agrees that financial regulation needs an overhaul - but how? How about changing the focus of regulation?
Clearly the current system of financial regulation has not worked. While a few commentators and academics argue that we need less, rather than more, regulation of financial institutions, legislators, around the world, have already embarked on coming up with new, hopefully better, rules covering financial services.
There will be much hot air expended on this topic over the next months and years, but it might be better to agree on what financial regulation is for, before trying to change it. As part of this debate, some principles for changing the focus of financial regulation are proposed below.
Principle 1: Regulation should focus on the consumer of financial services rather than the provider.
Current regulation focuses on monitoring corporate structures, which, as the failure to regulate the Structured Investment Vehicles (SIVs) at the heart of the current credit crisis illustrates, can be circumvented easily by determined Financial Institutions (FIs). Regulation should focus on protecting the consumers of financial services, using already highly developed consumer protection and product liability legislation.
# 2: Financial regulation should be enforced by national regulators, operating within internationally agreed conventions.
The current crisis has shown that capital can flow freely across national boundaries and can no longer be constrained by limitations on physical quantities, such as money, nor on multi-national corporations. Rather than knee-jerk curtailing of international flows of capital (and substitutes such as 'market value'), such flows should be encouraged as they provide the benefits of increased diversification for financial consumers. The model suggested is similar to that used, for example, to protect air travelers (Chicago Convention on International Civil Aviation) and the major question then is how can national governments protect the interests of their citizens and taxpayers, at home and overseas.
# 3: Financial institutions should be regulated on their ability to service their consumers' 'risk appetites'.
Though rarely articulated clearly, consumers of financial services have an appetite for risk and (should, but may not choose to) acquire financial assets and liabilities based on that appetite. Financial institutions should be aware of the individual risk appetite of each consumer and should manage their products and services to that appetite. This concept is already somewhat embodied in KYC (Know Your Customer) legislation for financial institutions.
# 4: Consumers should be free to adjust their risk appetite at any time, subject only to national legislation.
As their life and business circumstances change, consumers of financial services should be free to change their risk appetite and/or to rearrange their assets and liabilities into 'portfolios' of different risk appetites. They may also, of course, choose not to partake in the regulated system, subject to any national legal restrictions and without the benefit provided by regulatory scrutiny.
# 5: National legislation may place restrictions on how consumers, under their jurisdiction, may acquire or dispose of financial assets or use financial services.
Governments may choose, within agreed conventions, to promote or discourage the use of certain financial products and services for their citizens. For example, the tax system could be used to promote national goals on retirement and consumers may be encouraged, with appropriate tax incentives, to participate in funds with prescribed risk appetites but restricted from withdrawing assets until retirement. Likewise, national governments may require minimum levels of insurance in certain situations, such as minimum health or car accident cover.
# 6: Financial innovation should be promoted.
Far from being discouraged, innovations in financial services should be promoted and be protected by international conventions on Intellectual Property Rights (IPR). One mechanism for rewarding innovation might be for national regulators to formally license financial products for use in managing certain types of risk appetites [an example is the regulation of tax efficient Municipal Bonds in the US]. On the other hand, financial institutions should be opened to legal sanction under product liability legislation for misrepresentation of either product suitability of service capability. In particular, unregulated institutions would be subject, at least, to robust enforcement of consumer protection laws as regards mis-selling.
# 7: Ownership and value of financial assets and liabilities should be unequivocal and transparent at all times.
Consumers should have the right to be informed of the legal ownership of their financial assets/liabilities, including those where ownership is not direct but guaranteed by a third party (e.g. derivative securities). They should also have the right to a current valuation, including performance and risk, of any assets and liabilities managed or held by a financial institution.
# 8: Valuation, risk assessment and safekeeping should be functionally independent and be regulated separately.
In order to ensure ownership and value, the various stages of asset management should be independently regulated, especially risk assessment. If a financial institution were to perform more than one of these functions for its consumers, a 'Chinese wall' should separate these functions. Where regulators determine that an institution is egregiously deficient in any of these functions, the ultimate sanction should include the movement of any or all assets to another safekeeping institution. This principle is broad and does not distinguish between the types of services provided, e.g. insurance, banking, and wealth management and it does support the growth of niche players in specialist segments, e.g. pension fund risk assessment.
# 9: Consumers should bear the cost of compliance, while financial institutions should bear the cost of asset and risk management.
Financial institutions should be rewarded on their ability to match their consumers' risk appetites, including through the use of minimum capital requirements based on their risk management capabilities. Compliance costs for a regulated institution should be explicit and recovered from consumers through fees. Where a financial institution performs a 'public good', such as the circulation of cash by banks, it should be recompensed by its national government, for example, through the tax system.
# 10: Subject to international convention, national regulators should be free to regulate the conduct of financial institutions operating in their jurisdiction as they consider fit.
Since, as unfortunately demonstrated in the current crisis, taxpayers are the ultimate underwriters of regulation, national legislatures must maintain final control over their financial services infrastructure. While, in theory, national regulators may choose to exclude foreign financial institutions, in practice this has rarely happened in the recent past nor does it happen as regards other services, for example, civil aviation.
In summary, the model proposed in the principles above is an 'International Convention on Financial Services' through which consumers could purchase/subscribe to financial services supplied by local or international financial institutions - as, in air travel for example, when an American chooses to fly British Airways. The consumer would be assured that the service(s) provided are suitable for their needs (i.e. risk appetite) and that the provider is monitored, aggressively, for compliance with international risk/safety standards (as with, for example, the National Transportation Safety Board, NTSB, in the USA for air travel). Regulations could then concentrate on ensuring that providers of financial services operate to, and in some jurisdictions above, stringent safety and capability standards, as in aviation with the USA Federal Aviation Administration (FAA).
Of course, even though regulation may be strict, airline accidents do happen. Air travel consumers make risk decisions, choosing to fly small regional airlines to small airports in wintry conditions or large airlines to international hubs in good weather. Other consumers, of course, choose to opt out, piloting themselves in a small plane or, at the other extreme, as a passenger in an executive jet. All travelers are assured, however, that their aircraft has been certified as 'airworthy' and that minimum standards of maintenance have been recommended. In such a well-controlled environment, insurance can be used reliably to handle exceptional situations, such as accidents. A similar model for financial regulation would ensure that financial consumers were protected against wide spread systemic negligence, though failures could still occur.
The advantage of taking such an approach is that there already is a well-proven model for developing and enforcing such international regulations, through the United nations, which should greatly simplify the current regulatory alphabet soup, which is based on a complex combination of country, region, market, product type and type of institution. Furthermore, proven models for general consumer protection legislation already exist in all developed economies and there are already specific examples of protection for some financial services (e.g. US insurance sales). The disadvantage is that it is different to the current model requiring a new mind-set to implement and hence may fall foul of the sorts of delays that beset the Basel II process.
An obvious question is whether the Bank for International Settlements (BIS) could be the regulator in such a model. The answer is 'yes, partly', but only if it were split up. The primary role of the BIS is, as it describes itself, a 'meeting place' and a 'prime counterparty' for central banks - its focus is organizational and product specific. However, its experience and expertise in monitoring capital flows, as in its Quarterly Reviews, will be invaluable in any move to change international financial regulations. Likewise, while the World Bank (WB) and IMF are specialized agencies of the United Nations their focus is not on regulation pre se but on providing technical assistance on economic issues and trade. [Note the WB does identify financial crises as a 'global challenge']. The IAIS (International Association of Insurance Supervisors) performs a similar role to the BIS as regards international insurance regulation, but interestingly regards policyholder protection as its primary focus. In short, it should be possible to construct a new body from existing international regulators provided that national legislatures are amenable to moving to a new model.
The current unsightly turf war between the SEC and the CFTC (Commodities Futures Trading Commission) over the regulation of Credit Default Swaps (CDS), illustrates the dangers of myopic thinking focused on product/organizational regulation. Being USA based, neither of these regulators can handle the problems besetting the international CDS markets nor can they currently regulate insurance companies such as AIG.
A new paradigm for financial regulation is clearly needed and, as argued above, it must be international and based on the protection of financial consumers.
Posted by pjmcconnell at 06:42 AM
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October 18, 2008
Grande Bouffe II - French Farce
In all the gloom of the Credit Crisis, banking regulation in France can always be guaranteed to put a smile on one's face.
On October 17th, Caisse d'Epargne (CDE), a medium sized French retail bank, announced that the firm had lost some $800 million due to unauthorized trading in equity derivatives. The French Finance Minister, Christine Lagarde (real name - I kid you not), was livid and sent the French Banking Commission (FBC), the local regulator, to find out what had happened and to ensure that other banks were complying with market regulations.
But, zut alors, wait! Isn't that precisely what Mme. Lagarde sent the FBC to do after losses of $7 Billion at Societe Generale (socGen) just a few months before?
It was, of course, exactly what she asked and those comedy Clouseaus, the FBC, came back with 'rien', in fact 'rien de rien'; absolutely nothing; clean bill of health; tick in the box; all's well that ends well; back to the banquet before the main course.
In their report to the Minister*, the Krazy Kops reported that, although serious problems had been apparent for some considerable time, no fault could be found with the management and directors of SocGen, nor with the regulatory system, nor with the French government. It should be noted that the FBC relied on an internal inquiry, led by SocGen board members, to arrive at these startling conclusions. But to show they really, really meant business, the FBC fined SocGen the colossal sum of $4 million - ouch! French pride was restored.
What message did this fiasco send to other banks?
Experts, including regulators, agree that 'tone at the top' is THE key to creating a robust 'risk culture' in any firm. If the Board and senior management are not seen to 'walk the talk' as regards risk management, then how can ordinary staff take risk management seriously. What is the worst than can happen? A fine of $4 million - peanuts!
What can be expected from the FBC this time? I suspect much the same: pick and fire a few scapegoats; kick off an 'independent' inquiry; retire for long lunch; produce a report that says 'horrible mistake, one-off, could not have been foreseen, etc.'; stop for dinner; and then impose a slap on the wrist before retiring for a night-cap?
The situation is preposterous. Why has Mme. Lagarde not sacked the clowns at the FBC for incompetence and found someone more adept at complex financial investigations, such as Police Chief Wiggum of The Simpsons? Any report by the FBC is already compromised by their inability to properly regulate CDE after the SocGen affair.
While the last rites on Basel II might not have been pronounced yet, it is obvious that many of its concepts are already history, not least its 'home host' regulations. How can one take seriously a situation where one regulator has to defer supervision of a multi-national firm to its 'home' supervisor when that home-regulator is a weak as last year's Beaujolais Nouveau?
One further point is obvious! When the time comes to consider new regulatory architectures after the current crisis, existing banking supervisors should not be allowed anywhere near the deliberations. Most so-called 'senior regulators' have been tainted by scandals taking place under their very noses that they failed to act upon. How can they be trusted to come up with any new ideas?
The original 'Grande Bouffe' (the Big feast), was a cinematic masterpiece in which a number of very rich men succeeded in eating themselves to death on the finest gourmet food. The film was seen as an indictment of bourgeois overindulgence and has echoes in the recent excesses of the global financial markets. Regulators have been part of that intemperance when, though not indulgent themselves, they failed consistently to act decisively when deep-seated problems, such as over-consumption of debt, were apparent. They too should be judged.
That said the French regulators are clearly talented chaps and, if surplus to requirements in the new regulatory world, can find roles in one of the many re-incarnations of French masterpieces of farce, such as 'Le Cage aux Folles', literally 'cage of mad-women'. They would feel at 'home'.
In other entertainment news:
Johnnie Depp has agreed to play the lead, Jerome Kerviel, in 'Societe Generale - the Disaster Movie', with Helen Mirren as Mme. Lagarde (worth the ticket price alone), Frodo will play President Sarkozy and Herman Munster will have a cameo as Henry Paulson.
It is also reported that the BBC has knocked back 'Traders', the follow up to the hit 'Extras' by Ricky Gervais. The BBC stated that not even Ricky's genius could make the financial markets more excruciatingly bizarre than real life.
* See the previous blogs 'La Grande Bouffe' and 'SG + PWC = MIA' for details of the non-investigation by the FBC at Societe Generale.
Posted by pjmcconnell at 04:43 AM
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October 12, 2008
The Wealth of (Non) Nations
Does the Credit Crisis herald the end of the Nation State, if not in Politics and Economics but, maybe, in Finance?
How can the failure of a Californian homeowner to pay their mortgage, cause a diplomatic incident between two European powers (Britain and Iceland)? Because their sources of Finance are intricately and, I would argue, irrevocably interlinked!
Three irresistible forces link the Californian homeowner and the British account holder in a now-defunct Icelandic bank: financial innovation, globalization and technology.
Using the Internet, UK savers deposited money in Icelandic banks, such as Icesave and Landsbanki, to earn a few extra basis points on their savings. Unfortunately, Icelandic banks appear to have overstretched themselves, falling foul of the lack of liquidity in the world's money markets and have had to be partly nationalized by the government. In turn, the liquidity crisis was precipitated by failures in the US capital markets due to US banks and hedge funds investing in complex derivative securities, such as Credit Default Swaps (CDS) and Collateralized Debt Obligations (CDO), many of which were based on sub-standard (so called sub-prime) mortgages sold to over-stretched borrowers in California and other states.
So what's the problem with just banning controversial products such as CDO and CDS? In short, it won't work.
Just a quarter of a century after Adam Smith published 'The Wealth of Nations' in 1776, workers began to destroy wool and cotton mills throughout the North of England. The so-called Luddites (named after the fictitious Ned Ludd), were terrified that their livelihood would be destroyed by the new automated looms that could produce much more work, at a much lower cost, than a skilled weaver. The Luddites were right; their traditional trades were ruined in what became known as the 'Industrial Revolution'. The Luddite movement lasted only a few years, put down by, forcefully, by the British government who executed some leaders and transported others to Australia, as convicts.
The genius of Adam Smith was to point out how technology, and changes in working habits, could be beneficial to the community, as a whole, provided that capital was freed to underpin the new markets that would be created by the new technology.
The financial Luddites who call for banning financial innovations, such as stock borrowing for 'short-selling', cannot succeed beyond short-term populist rhetoric; the genie is out of the financial bottle and must be managed rather than ignored. True, like the peasants who, with torches and pitchforks, attacked the homes of the rich mill owners, it is satisfying to see modern robber barons, such as the CEOs of investment banks, being roasted by politicians. But that is a sideshow and not really relevant to fixing the current dire situation?
The tools that national governments employ today to manage their financial systems, such as interest rate management and currency controls, only work within their geographical borders, or within single currency blocs such as the European Community. Nobel prizes have been won describing how 'money supply' may be managed to achieve national economics goals but the latest meetings of the G7, G20 and IMF, show that the only (?) way that such global problems can be solved is by, the euphemism, 'global coordination'. In short, national regulation is not sufficient to handle global markets; something else is needed, but what?
The problem is that the global markets deal not only in money or other physical commodities, such as gold and oil, but in amorphous concepts, such as 'market value'. For example, when a Credit Derivative Swap (CDS) is bought, only a relatively a small amount of money changes hands - the premium. In global terms, such premiums are peanuts compared to other money flows, rarely registering on the radar of financial regulators. However, behind such a contract is a promise to pay a potentially huge amount if the contract is ever exercised, e.g. when a firm defaults when underwritten by a CDS. For example, a US insurer, such as AIG, can sell credit-protection to a Belgian bank based on the credit-worthiness of a US investment bank, such as Lehman Brothers. Not a lot of money changes hands up-front (just enough to guarantee bonuses for all concerned), but when a default happens and the Belgian bank turns up for their money, the cupboard may be bare.
This would not be (too much of) a problem, if the markets were small and localized; however the markets are gargantuan and global. In its quarterly review* of international banking in September 2008, the Bank for International settlements (BIS) noted that the turnover in 'nominal value' for all derivatives for the quarter was some $60 trillion. Note that the IMF has estimated that the GDP for the whole world for the year was roughly the same size and the total nominal value of derivatives contracts outstanding was some 10 times greater. The market for derivatives is truly global and is largely unregulated, even under the new Basel II regulatory regime.
Re-regulation is the war cry! But if we cannot regulate such a globalized market using nation-based regulations, what can be done?
The first steps must include identifying the goals of regulation, which in turn means identifying the needs of various 'stakeholders' or 'Communities of Risk Interest' (CRI).
The concept of such a community already exists in the financial markets; shareholders are one example. Today for example, an investment fund in Australia finds it easy to hold shares in companies on listed US and European markets or to buy/sell options on Asian derivatives exchanges. There is little that an Australian regulator can do about such strategies, other than ensure that the investment managers observe corporate disclosure requirements. For regulated investors, such as Insurers, regulators require that they maintain reserves to cover all risks but pay little attention to where risks are taken. Forcing investors to return to investing within national borders will not work. For example, BHP Billiton, one of the largest companies in Australia, is listed simultaneously on Australian, UK and US exchanges: what does it mean to buy BHP shares in Australia - not a lot!
But 'shareholder' is a term that actually covers a variety of interests, including individual shareholders and fund managers. Fund managers, in turn, support different communities, including: pensioners, future pensioners, individuals and local governments. It is obvious that these communities have different objectives and different risk appetites, from risk seeking (future pensioners) to risk averse (pensioners). Other than ensuring at least partial compliance with 'investor mandates', there is little regulation of this ocean of money sloshing around the global markets, other than national corporate laws. In the past, regulation has been delegated to an alphabet soup of entities that were originally based on some form of corporate structure, e.g. national banks, regional banks, investment banks, insurance company, pension funds etc. Such segregation has become increasingly irrelevant, as huge firms, such as JP Morgan, have brought multiple financial services under one brand. The recent chameleon change of regulator by Goldman Sachs and Morgan Stanley (without changing their underlying businesses) illustrates the sheer irrelevance of the current regulatory structures.
What if regulation was based on communities of risk interest/appetite rather than national corporate structures? For example, if pension payment funds were to be regulated against the amount of risk taken over a relatively short horizon, rather than gross size, then the danger of taxpayers having to bail out pensioners would be reduced. Likewise pension accumulation funds would be measured and regulated against a much higher risk appetite over a longer horizon and hence a lower likelihood of needing taxpayer intervention. At the other extreme, pure market speculators, such as hedge funds, would hardly be regulated at all, except to ensure that their risk taking activities do not impinge upon or bleed into other communities. It should also be noted taxpayers are also a community of interest, with minimal appetite for risk, in this context.
Given that it is quite reasonable for a community to spread its risk around the world, any regulation would have to international. The questions then become: (a) what would be a community of risk interest and (b) how would such international regulation work.
CRIs would coalesce around a common appetite for risk and, for example, could include not only pensioners but also, at the other end of life, school leavers, hoping to build a career and long wealth. Homeowners could be another community, with a range of risk appetites but with a common dislike of volatility. Local government and charities, with funds on deposit while waiting to spend, could form another community with a low risk appetite but with flexibility being key requirements. There are other potential communities of risk interest, including businesses of different types.
The next question to ask is: are risk appetites purely local or is there commonality across national boundaries? While the size of the pot may be bigger, the risk appetites of US, UK, European and Australian pensioners, for example, would be similar - a strategy that would ensure sufficient money to live in acceptable comfort until death.
Finally, how would such regulation work? Obviously, laws are made within national legislatures and national regulators must be accountable to local taxpayers, but there are many examples of regulations that are harmonized across national boundaries.
For example, civil aviation around the world is regulated by the International Civil Aviation Organization (ICAO), through flight safety organizations in its member countries. ICAO is successful because nations agree that the lack of good air safety standards endangers its citizens not only traveling overseas but when foreign flights land at their airports. Individual travelers too feel confident, when they board a commercial aircraft anywhere in the world, that there are basic safety standards that the airline should be following (though some are obviously better than others). Likewise there are international standards on topics as diverse as shipping (international Maritime Organization) and Telecommunications (ITU).
The key point about these organizations is that there is recognition that there are common problems (risks?) that are best tackled by cooperation, rather then conflict, between countries, regardless of their political system. Such cooperation does not diminish competition but, on the contrary, the most efficient and least risky firms/countries tend to rise to the top.
While on the face of it, the Bank for International Settlement BIS) might appear to be such an international organization, its focus is not on protecting the end users of finance, and ultimate creators of wealth, but only one community, banks. It is community of poachers not gamekeepers!
When the dust eventually settles down after the Credit Crisis and we turn to thinking about how financial regulation should change, there should be no return to the cold spaghetti of national regulators. Legislators should look much wider and consider international regulations, such as ICAO, to protect the end-consumer of finance rather than hoping that regulating intermediaries will protect the system as a whole - that hasn't worked.
In such a regime, whenever a financial firm collapsed, we would be able to examine its financial "black box" to identify underlying causes, defects, and responsibilities and then to draw lessons for the future. As with aviation, we could then 'ground' all firms that had the same problem, instead of waiting until there is a major crash.
* BIS (2008) "International Banking and financial Markets Developments" Quarterly Review September www.bis.org
Posted by pjmcconnell at 04:35 AM
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