It is not yet clear whether international banks will yet again manage to work around efforts to tighten financial sector regulation and return to business as usual. To ask the question starkly, will financial market interests win over those of dispersed taxpayers? This article reviews the various financial sector regulation proposals that are under consideration in Europe, the US and in the Basel Committee on Banking Supervision (BCBS) and G20 forums, and highlights issues which are material.
On June 16, 2010, the British chancellor of the exchequer (finance minister) announced that the Financial Services Authority (FSA) was to be split up and the Bank of England’s regulatory jurisdiction over banks was to be restored. However, banks in the UK and Germany with single regulators as well as those in the US, which has multiple financial sector regulators, were all severely affected by the financial sector crisis in 2008. Currently, Europe’s sovereign debt concerns have overshadowed its efforts to improve financial sector regulation and rein in leveraged bets (leverage defined as the ratio of total risk-adjusted assets to equity). Separately, there has been widespread criticism in continental Europe of the two US-based credit rating agencies — Standard and Poor’s and Moody’s. However, as of now, there is no specific initiative to set up competitors.
On June 25, 2010, the US Congress and Senate agreed on a reconciled version of the Dodd-Frank Bill on Wall Street Reform and Consumer Protection. A few sample features of the proposed law, which is over 2,300 pages, are as follows: (a) the Volcker idea to ban deposit-taking banks from engaging in proprietary trading has been diluted and banks would be allowed to invest 3 per cent of their Tier-I capital in private-equity and hedge funds; (b) financial firms would not be allowed to trade asset-backed securities which they have underwritten; (c) banks would be allowed to trade interest-rate and currency swaps but other over-the-counter (OTC) products such as credit default swaps would be traded on regulated exchanges (OTC products constitute one of the most profitable business segments for global banks). It is likely that the proposed legislation, which is long and complex, would lead to protracted legal disputes over interpretation. The Bill also falls short on crucial issues, for example, it does not cap leve rage and restrict all trading of exotic OTC derivatives to exchanges.
Nout Wellink, the current chairman of BCBS, spoke on regulatory reform at an Institute of International Finance meeting in Vienna on June 11, 2010. Mr Wellink’s remarks encapsulated Basel III proposals, namely: (a) capping of leverage; (b) adequate liquidity, including banks being able to manage for 30 days without access to money markets; (c) quality of capital, i.e. Tier-I capital to be restricted to common equity plus retained earnings; and (d) improvements in accounting norms.
The Financial Stability Board (FSB), set up by the G20, released reports in April and May 2010 on improving financial stability. These reports focus on: adequacy and quality of capital and liquidity; improvements in OTC markets; reforms in compensation practices; strengthening of accounting standards; and dissemination of balance sheet data.
More recently, the last G20 Summit meeting took place in Toronto on June 26-27, 2010. It seems unlikely from the section on financial sector reforms in the Summit communiqué (paragraphs 15-22) that Basel III capital adequacy and liquidity norms would be implemented by the earlier intended date of end-2012. Additionally, the proposal for banks to limit duration mismatches between assets and liabilities seems to have been dropped. This was expected since some eurozone countries need time to reduce their debt overhang and many large banks have illiquid assets on their books. Accordingly, it has been argued by financial sector proponents that enhanced capital requirements at this stage would prove to be the proverbial last straw for banks. At the same time, given the concerns among investors, the results of stress tests for 91 European banks are to be released on July 23, 2010.
This fleeting review of proposals for financial sector reforms may leave some readers confused about which are the principal issues that matter. Further, it can be anticipated that the “empire” (read recalcitrant banks) will strike back and try to obfuscate and thereby delay the implementation of enhanced capital adequacy norms and proposed regulations for OTC derivatives and securitisation. The currently envisaged bank levies and taxes on financial transactions could raise about $50-100 billion per annum. Therefore, unless there are much higher charges on all transactions for which there would be no consensus, the amounts collected would be too small to pay for the 2008 crisis or for a future financial sector meltdown. Public memory is short and people will soon forget that during the two years, 2008 and 2009, the loss in global output, as compared to potential, was at least 5 per cent of world GDP, or about $3 trillion.
If financial firms claim the distinction of having provided very high rates of return on equity, this is invariably unsustainable or undesirable since it is based on leverage, monopoly pricing or information asymmetry. Consequently, if governments are serious about reducing the probability of future demands on taxpayers, higher amounts of risk capital have to be set aside for seemingly low probability default events. It follows that bank lending and credit extension activities would be reduced. However, this should be acceptable since entire economies suffer large losses in terms of foregone growth as a result of periodic financial sector blowouts.
To summarise, four elements of financial sector reforms which need to be fully implemented at the latest over the next three years are: (a) higher levels of Tier-I capital (conservatively defined) to protect against insolvency; (b) adequate liquidity to tide over a temporary shutdown of money markets; (c) verifiable valuation of assets and accounting standards which are rigorously applied; and (d) re-imposition of an improved version of the Glass-Steagall Act which segregated commercial banking, including deposit-taking, from investment banking. If these reforms were to be carried out, the sustainable return on equity for financial firms would be comparable to that for real sector companies. This should be a desirable outcome since it is the lure of astronomical profits in the short term which fosters highly leveraged non-transparent risk-taking in the financial sector.
The author is India’s ambassador to the European Union, Belgium and Luxembourg. Views expressed are personal
