Gangadhar Darbha: Partnerships in regulation
Financial market regulation is too important to be left to regulators alone
Much the same way financial crisis spreads through countries owing to the inter-linkages between asset markets across geographical regions established by coordinated or uncoordinated interactions between various banks, hedge funds and so on, the realisation of and response to the crisis by the governments and regulators across the globe is also spreading in both a coordinated and uncoordinated manner. There seem to be a consensus among governments and regulators across countries that financial markets require much more effective regulation than has been done in the last two decades. However, there is much less clarity, let alone agreement, on how exactly one should go about doing so.
The proposed Dodd-Frank regulation in the US is leading the way in recommending the most comprehensive changes that are expected to have far-reaching consequences to the functioning of banks and financial institutions both for the US and the rest of the world. The recommendations range from restructuring global financial institutions, increasing coordination among regulators within and across countries for more effective monitoring of risks, identifying systemically important (“too-big-to-fail”) financial institutions and subjecting them to special monitoring and additional capital charges, creation of smooth bankruptcy and conflict resolution mechanisms and creation of market microstructures (i.e. trading, clearing and settlement infrastructure) that would substantially improve the degree of transparency in the price discovery mechanism in hitherto over-the-counter (OTC) derivative markets. This exhaustive list of recommendations is finding its way, in some form or other, in to the halls of governance and regulation of not just the US, but across the globe. Similar concerns are being raised in India, with various committees looking into aspects of the regulations required for our markets in the newly proposed global financial architecture.
An important issue that is conspicuous by its omission from this list and the discussions in general is the required changes to the internal organisation of global banks and financial institutions. While a great deal of attention has been paid to the issue of (perverse) incentives that have led to excessive risk-taking and subsequent collapse, very little attention is being paid to the collapse of the internal checks and balances within these global organisations during the run-up to the crisis.
Seldom did one hear of regulators and policy-makers asking why internal audit departments, chief risk officers and board members do not see the erosion of the quality of the balance sheet and excessive risk-taking by front office. It is simplistic to think that banks and financial institutions have monolithic internal organisational structures with everybody having the same objective of maximising profits and no checks and balances to control excessive risk-taking. On the contrary, even a casual look at the internal organisation of any global financial institution will reveal that they are fairly complex organisms with multiple layers of decision making built-in with different layers having different goals, responsibilities, and performance indicators. More importantly, they are structured in such a way that some layers of organisation are authorised to act as a monitoring and control mechanism on the others, so that no single layer of management can run away with its own selfish motive to the detriment of the organisation and the financial system.
For example, a chief risk officer who heads the mid-office has the mandate to question whether there are excessive risk-taking practices and draw the board of directors’ attention to them. The board, in turn, has the authority to regulate the CEO about overall practices that may have adverse consequences to the firm. In that sense, these organisations are created to facilitate interactions among (potentially multiple) principals with multiple agents to minimise the standard problems of moral hazard and adverse selection associated with a textbook principal-agent problem.
The moot question, then, is why these internal organisational structures that were built assiduously over decades fell apart when they were needed the most in the run-up to the crisis. Part of the reason is the lack of appreciation of the externality-effect that these global institutions are having on the system and its consequences to their own financial health. It is also due to the convergence of the wishes of investment bankers, regulators and policy-makers, a phenomenon that Professor Raghuram Rajan calls the fault-line. Coupled with supportive public policy to create, trade and fund excessively complex and risky instruments, front office managers had a field day convincing and coercing the rest of the organisational structure into a frenzy of risk-taking. Internal risk-management offices, despite being best placed to raise an alarm about the nature of the risks that were created but having not got an explicit regulatory support, could do very little in the euphoria of unprecedented apparent gold-rush in financial markets.
Under the assumption that everything in the private financial system has gone wrong, the governmental response to crisis, as expected, is focusing excessively on what various regulatory agencies (within and across countries) can do to set the best practices in global financial markets back on track. This top-down approach cannot achieve a stable financial system unless one finds a way to empower the internal risk management systems within systemically important financial institutions. It must be understood that the risks underlying global financial markets will continue to be as complex as in the past, and the regulatory capacity to measure, monitor and mitigate those risks will be too low to be sufficient.
The creation of public-private partnerships in regulation is an important way by which regulators can leverage the skills of private sector in identifying the risks that are being created, and control the same by empowering the internal checks and balances within global financial institutions. Having an explicit regulatory support to their function will enhance the capabilities of internal risk and audit systems in escalating the risks of the business at appropriate forums in a timely manner. Private sector on its part will have to understand and cooperate in such partnerships since the creation of an organically-stable financial system will lead to better internal risk-management practices, lower capital charges and higher quality balance sheets. There will be many issues with regard to the details about incentives and conflicts of interests, but they all can be worked out once the value of the public-private partnerships are recognised.
The author works with an investment bank. These views are personal. gangadarbha@yahoo.com