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.
