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February 2010

The past, present and future of regulations

The roles of monetary authorities, need for harmonization and reform, new tools and models, were underlined at The NUS Risk Management Institute's breakfast dialogue in December.

The NUS Risk Management Institute in collaboration with the NUS Business School organized a breakfast dialogue on the theme of "The past, the present and the future of regulations for financial institutions" on Saturday, 19 December, 2009 at the Shangri-La Hotel in Singapore. Panelists Dr. Malcolm D. Knight (Vice Chairman, Deutsche Bank Global Group, and Visiting Professor in Finance, London School of Economics and Political Science) and Ms. Teo Swee Lian (Deputy Managing Director, Prudential Supervision Group, Monetary Authority of Singapore) presided, with the dialogue moderated by Prof. Franklin Allen (Nippon Life Professor of Finance and Professor of Economics, Co-Director, Financial Institutions Centre, Wharton School, University of Pennsylvania).

The timely theme of the dialogue as regulatory authorities grapple with the aftermath of the crisis was reflected in the high attendance, notwithstanding the early Saturday morning timing of the event.

Prof. Bernard Yeung, Dean of the NUS Business School made the welcoming remarks introducing the panelists, pointing out the importance of the theme.

In his opening comments Prof. Allen characterized the crisis as a complex event with many causes, amongst which two were the most crucial: a loose monetary policy during 2003-04 and global imbalances. The combination of low interest rates and easy availability of credit had led to the creation of a property bubble, and when this burst, problems in the banking sector and eventually a financial crisis ensued. By keeping interest rates at 1% when property prices were rising at 8%, the public sector had taken on significant risks, he pointed out. Prof. Allen also feared that in the current scenario, the US economy was headed back for another crisis. Monetary policy was excessively loose and the private sector had taken on too much leverage. The much needed changes in regulation are unlikely to take place as modern banks have become increasingly difficult to regulate. Through trade they are easily able to change their risk profile and evade the demands of higher levels of risk capital. He suggested that large banks should not be seen as "too big to fail", but are, instead, too big to liquidate. Through their widespread global operations, they continue to remain a major source of contagion.

A preventable event

Initiating the discussion, Dr. Knight painted the crisis that started in August 2007 as a preventable event. Global losses have now amounted to over US$1.1 trillion. The massive level of deleveraging in the banking system accentuated the vulnerability of the financial system, while the originate-to-distribute model made increasing leverage easier for the banking system. He then asked the audience to bear two points in mind. Firstly, the financial system contained shock amplifiers in the form of rapid growth in credit and asset prices, but no shock absorbers. Mechanisms for transmission of contagion that had developed over the decade accelerated the global spread of the crisis. There is hence a pressing need for policy makers to develop and strengthen shock absorbers. Secondly, the regulatory system also needed to keep track of innovations and associated risks, given the fact that the originate-to-distribute coupled with deleveraging had greatly increased the vulnerability of the financial system.

As for the future of financial regulation, Dr. Knight saw a need for intervention only in the event of market failure, especially in the event of a build-up of systemic risk. Pervasive information asymmetries showed up in particular during the crisis; large institutions possessing superior information had an intrinsic advantage in the form of better information. The crisis underscored the need for harmonization of regulation across the globe as well as a reform of the architecture of international financial regulation. He saw a pressing need for international harmonization of regulation; or else systemic risk would continue to threaten the financial system. Financial institutions could exploit opportunities for regulatory arbitrage leading to distortions in international financial markets. This made a case for strengthening the capital base of financial institutions. Reforms need to focus on interbank markets pointing towards the need for an international facility through which banks can lend to each other. The major weakness in the current reform process is the focus on individual firms to the neglect of systemic risk. As such, the absence of a harmonized effort to deal with systemic risk and solvency regulation could undermine the post crisis reforms.

Of bubbles, hubris and failure to connect the dots

Ms. Teo next spoke of the need for principles-based regulation. A cursory look at financial history reveals a pattern of cyclicality in crises, with similar root causes throughout history. She defined the current crisis in three words: Bubbles, Hubris and a Failure to connect the dots.

Bubbles have developed throughout history. In Asia as was the case in 1997, a bubble built up in the housing market - the current crisis was an instance of history repeating itself. Skepticism about rising markets was essential. There was a need to lean against the wind. Ms. Teo felt it was incumbent upon policymakers and regulators to take appropriate, often unpopular steps. Market watchers were also culpable as they failed in their monitoring role.

Hubris was reflected in several phenomena. Unchecked greed was reflected in the eighties through the character of 'Gordon Gekko' in Wall Street, and the sobriquet "Masters of the Universe". The belief that quantitative models captured all risks underlay many of the problems that banks encountered later. The emphasis of the Basel II accord on Pillar 1 was at the heart of the inability to monitor market developments and growing financial fragility. In the United States, financial institutions failed to capture off balance sheet activities. Ms. Teo spoke of the importance of monitoring leverage ratios. As an illustration, strict control over and monitoring of leverage ratios worked in Canada. Regulatory authorities there allowed fewer exemptions. Leverage ratios provide a useful reality check, a viewpoint recently endorsed by the Basel II committee. Banks need to harmonize leverage ratios, including the methodologies for calculating them.

Banks also need to move to a risk based approach. Speaking of the need for greater thought and clarity in the definition of capital, Ms. Teo mentioned that models should incorporate liquidity and systemic risk - areas where there is a need for further quantitative studies.

The 'failure to connect the dots' and observe the linkages, was pervasive. Macro-prudential regulation needed to provide guidelines on how to identify systemic risk, but had clearly failed to do this. The impact of subprime loans was a graphic illustration of so failure. The unregulated sector, especially shadow banking was another illustration of this gap. In the monetary authorities' preoccupation with hedge funds, regulators and market participants had failed to recognize problems with counterparty risk for the rapidly growing market in credit default swaps. Going forward, Ms. Teo argued for balanced approach to regulation. The fixation with size, rather than impact was yet another instance of a collective failure to address the issue of interconnectedness. Authorities need to change their view to focus on impact rather than size alone.

The Asian Financial crisis of 1997 had been a good dress rehearsal for banks in the region. Since then, banks had developed a healthy respect for risk management. Furthermore the real sector had picked up, and banks confined themselves to traditional functions. Limited development of securitization, and fortunately for local banks, low or negligible exposure to securities based on subprime loans had kept Asian banking systems relatively insulated
during the current crisis. Again, Ms. Teo reiterated the need for skepticism. Financial regulation is not the golden bullet for potential failings in the financial system. The first line of defense should be good corporate governance and effective oversight by the board and senior management.

New tools and thoughts

A lively question and answer session followed the dialogue. In response to a question on the political will required for regulation, Ms. Teo emphasized the need for a political pillar to accompany Basel II. However, she pointed out that this would require radical changes to the existing system as there is no basis in international law for such a provision. The issue of rules vs. discretion needs to be examined in detail. The close links between financial institutions and financial markets underscore the need for incorporating systemic risk into assessment of overall risk. Dr. Knight again emphasized the need for developing shock absorbers. A shock to the system will result in liquidity drying up in the banking system, directly impacting financial markets. Ms. Teo also suggested that the International Monetary Fund's Financial Sector Assessment Program should be expanded in scope, and underlined the need for a new toolbox. The panelists also highlighted the role of monetary policy as well as fiscal policy to prick bubbles.

Prof. Allen added that central banks are not always best suited for making credit risk decisions. He envisaged a role for public sector commercial banks, which would possess the expertise lacking in central banks, and also have the ability to expand during times of financial duress. Dr. Knight also brought up the need for market determined exchange rates in addressing the role of global imbalances. The panelists had differing perspectives on the role of leverage. Dr. Knight contended that leverage should be incorporated in Pillar II rather than in Pillar I of Basel II. The build-up of systemic risk had been crucial to the spread of the crisis. It was not visible to the monetary authorities: while systemic risk was rising, traditional measures of risk, such as volatility suggested otherwise. A good measure of systemic risk would be very useful. Comparing leverage ratios across institutions with different risk profiles was not helpful. It suggests a need to place leverage in Pillar II and not in Pillar I.

This would allow greater transparency in assessing an institution's risk profile. The G20 groups conversely had suggested leverage in Pillar I. In response to a question on the need for bank level data, Prof. Allen agreed that there was a pressing need for more data. Data is also needed to help shed light on the questions of how in an industry that was ostensibly competitive, banks are able to make such extraordinary profits and offer compensation packages to executives that are widely regarded as excessive. Furthermore even large banks are unable to make judicious use of data available. He quoted an example of lack of coordination between the investment banking and commercial banking operations within the same bank. Disclosure continues to remain a contentious issue. The dialogue concluded with a final query on the imperative need to accelerate efforts towards early identification of financial crisis. Prof. Jin-Chuan Duan, Director of NUS Risk Management Institute concluded the proceedings by thanking the speakers for an extremely engaging discussion and the audience for their lively participation.

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Published quarterly by Risk Management Institute, NUS
Editor: Ivy Wang (rmiwy@nus.edu.sg)