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Financial Crisis - Ideal Outcome

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It is clear that when the G20 meets in Seoul this November, there should be a firm proposal for the Basel Committee and the Financial Stability Board for dealing with the banking behemoths. Banks should then comply with the new capital requirements agreed by finance ministers by January 1, 2019. The question is, however, whether this is the right path to choose and whether these regulations will be able to prevent the world from any future financial markets crisis. So far, the proposed numbers themselves could hardly be described as tough, as the bounce in bank shares testified. Also, it seems that many important issues are not being addressed at all. (Plenty) But what are the issues that should be addressed? What would be the ideal regulatory state and is it possible to ever achieve it? Let us, first, start with our idea of the “ideal” international financial regulatory plan.

After having researched various proposals for the international financial markets regulations, we reached a conclusion that finding the ideal path is going to represent a very difficult task and that none proposed regulation will be able to fit all the states. As mentioned in the article “Financial regulation: More questions than answers” which was posted in Businessline in the end of July, due to the variations in institutional legacies, traditions and systems in individual countries over the world, no one size can fit all. Also, however, we believe that as far as financial stability is concerned within any kind of arrangement that is deemed fit in a particular country, there is no need for a central bank to have a lead role. (Opinion) Any regulations will then require a dispassionate assessment of the reasons for the current system’s failure. The complicated issues, which need to be addressed, include the appropriate degree of protection for financial institutions, the regulation of nonbank entities (such as hedge funds), and the determination of adequate capital levels. In all these fields, “Brave—even radical—changes” will most probably be necessary. (Butler)

We are also convinced that when implementing any regulation, the cooperative approach will have to be adopted. As presented in another McKinsey article called Managing regulation in a new era, regulation is a “game played over and over”. It can be often seen that companies persuade regulators that it is not the right time to allow more competition, they ask for reduced emissions and are against higher service obligations, or whatever just to perform much better than the regulators expected in the ensuing regulatory period. Usually, regulators would react to attempts to fool them by enacting a much stricter settlement in the next round. In extreme cases, when the trust falls to minimum, regulators and companies are forced to communicate through third parties. This is then true for any kind of companies, including also financial institutions. In the 21st century, global economic and sociopolitical challenges have become more acute, and the contract between business and society has expanded. Due to these reasons, it has become more important for executives in various sectors of the economy to think about their approach to regulatory issues. In order for the system to work, executives and also regulators have to realize that they do not necessarily have to bee adversaries. (Beardsley) It is necessary for the society to realize that if there is trust, regulation can become, as adequately expressed by McKinsey, “a mechanism for industry-wide, even global, cooperation on issues ranging from financial prudence to scientific innovation and climate change”. When creating any regulation, both regulators and companies have to engage each other in an environment that promotes fact-based analysis and trust. In order to achieve this, regulators then have to fully understand the economic and long-term dynamics of the industries they oversee and companies must look for inherently sustainable solutions. Executives must adopt flexible approaches and have to be willing to make trade-offs. (Beardsley)

What is also necessary in order for the new regulatory environment to be successful is transparency and trust. Again, we have to agree with the argument of McKinsey that as to be able to achieve a productive relationship between regulators and companies, the individual sides have to understand the perspectives and objectives of the opposing party. They have to be able to understand these to such a point so that crafting of solutions meeting the needs of both sides is possible. This does not mean, however, that companies and regulators have to show all of their cards. Rather it means that they have to discuss both, short and long term issues, and then share the substantial information in detail. Due to the fact that companies and executives have usually better understanding of the economic challenges than regulators have, trust and transparency are necessary for the achievement of balanced and sustainable regulations. Moreover, an open and long-term relationship with regulators provides the companies with the opportunity to shape the regulations in a way that is more suitable for them. This can be then beneficial for both parties as they can learn from each other and thanks to this the most efficient solutions can be reached. (Beardsley)

After having discussed the general framework of the regulations and especially the environment in which these should be formed, individual regulatory categories will be analyzed. One of the crucial issues is then the tackling of the “too big to fail”. It is undisputable that large bank’s failure represents risks to other institutions, the financial system, and consequently the whole economy. Due to this reason, regulators often adopt approaches that protect not only the bank’s depositors but also all the creditors (or even shareholders) from losses they would otherwise have to face. Those banks, which are usually protected by such measures and for which governments are often willing to intervene, are considered to be “too big to fail”. The main problem with such an approach is, however, the fact that such a protection tackles the problem only temporarily, and instead of preventing future problems, it increases longer-term systemic risk. This is due to the fact that creditors and investors are less pressured to monitor these “too big to fail” banks. Also, the managers of these banks are less afraid of taking excessive risks. Even though in the past governments tried to mitigate the morel hazard element by ambiguously choosing which banks to rescue and which not, the recent rescues have made the world believe that no large financial institution will be allowed to fail. (Butler)

In this respect the theory that seems to be the most appropriate to us is that promoted by Paul Krugman. This world-known economist is a big advocate of much strengthened financial regulation. He, however, completely opposes the idea that the financial institutions should be shrunk down to the point where none of them would be too big to fail. He considers this to be impossible and irrational. According to Krugman, finance is deeply interconnected which means that even a moderately large player can take down the system if it implodes. This opinion he supports by the fact that it was Lehman and not Citibank or Bank of America that brought the world to the brink. According to him, the world in which everyone is small enough to fail represents a new, golden age, and the best approach is to regulate, supervise and then rescues if this is necessary. Never the rescue should be, however, automatic. (Krugman)

Therefore, the proposals from the G20 and others, who recommend regulating and supervising large, complex financial institutions more tightly seem to represent the right approach if not taken into extremes. Measures, which would be discouraging institutions from becoming too big, might be adopted, however, it has to be taken into account that complete elimination of huge financial banks is impossible. When regulating and supervising financial institutions, we partially agree with the article “Learning from financial regulation’s mistakes” which suggests that antitrust approaches originally designated to prevent markets from becoming too concentrated can be used. Added to this, additional capital charges or insurance fees on institutions could be levied in proportion to the level of systemic risk they pose. In reality, this would be a way of charging a market price for the “too big to fail” guarantee. In a national-level, regulations of the subsidiaries and branches of international banks should be stronger as these could ensure that the impact of their failure was contained. Definitely, the investment and commercial banking should be then kept more separate than they are at the moment. Along with prevention, a cure should be developed. This represent a creation of a system for liquidating large banks which would allow for the control of systemic risk and would ensure that investors, creditors, and managers bear sufficient pain to eradicate moral hazard. The idea of immediately transferring good assets to a new, smaller but shiny “bridge bank” also seems to be a good one. By the adoption of this approach, uninsured creditors would be left not only with a “bad bank” holding troubled assets but also with some equity in the new institution. (Butler)

In the question of the separation of investment and commercial banking, the view presented by Volcker effectively addresses the problem. Paul Volcker, who is a former Federal Reserve Chairman, agrees that commercial banks should be separated from investment banks in order to avoid another crisis. He proposes a kind of “two-tier financial system” in which commercial banks would provide customers with depository services and access to credit and would be highly regulated. On the other hand, securities firms would be allowed to take on more risk and practice trading, being rather free of regulations. At the same tmie he would, however, allow commercial banks to continue with underwriting and providing of merger advice, which are activities usually associated with investment banking. Still, however, he considers necessary for some banks to exit certain businesses if they want to remain commercial banks. According to him, these activities should encompass heavy proprietary trading and hedge funds. As to be able to prevent another financial crisis, international regulations on financial firms are inevitable. Generally, he proposes a radical change of the entire system, as he believes that: “There is something wrong with the system”. (Benjamin)

Another area, which also has to be addressed, is the shadow banking system. This is represented for example by hedge funds, private-equity funds, pension funds, insurance companies; credit default swaps contracts, and off-balance-sheet vehicles. Even though it is undisputable that the shadow banking needs to be regulated, any regulations in this field have to be adopted with special care as they impose real costs on society. The major problem may increase in case when prudential regulation “creates anticompetitive economies of scales, impairs innovation, adds costs, helps preserve weak management and business models, and passes the pain on to taxpayers if institutions falter”. (Butler) Also, as mentioned in the article “Learning from financial regulation’s mistakes”, any hedge or private-equity funds stand for systematic risk. The main issue with financial institutions other than banks is the fact that these tend to borrow for a specific term or against collateral. Unlike banks, which have to repay majority of their liabilities on demand and with which any failure to do so has a falling-domino effect, in the case of other financial institutions, investors and creditors lose money but not immediate access to cash. Therefore, the same level of supervision and regulation is not required for both categories.

In terms of hedge funds, which seem to represent the highest level of systematic risk, the The International Organization of Securities Commissions’ (IOSCO) Technical Committe Principles for Hedge Funds Regulation offers possible solution to the problem, if adopted worldwide. These principles require hedge funds and/or hedge fund managers/advisers to be the subject to mandatory registration. Also, they should be subject to appropriate ongoing regulatory requirements relating to organizational and operational standards; conflicts of interest and other conduct of business rules; disclosure to investors; and prudential regulation. These managers and advisers should be also prime brokers and banks, which provide funding to hedge funds, should be subject to mandatory registration/regulation and supervision. Moreover, they should have in place appropriate risk management systems and controls to monitor their counterparty credit risk exposures to hedge funds and should provide to the relevant regulator information for systemic risk purposes. Regulators should then encourage and take account of the development, implementation and convergence of industry good practices, where appropriate and they should have the authority to co-operate and share information, where appropriate, with each other, in order to facilitate efficient and effective oversight of globally active managers/advisers and/or funds and to help identify systemic risks, market integrity and other risks arising from the activities or exposures of hedge funds with a view to mitigating such risks across borders. (IOSCO) We strongly believe that if these, or similar measures are applied also to other financial institutions, systemic risk could be significantly limited.

Coming to the overall aspects of regulation, we agree with majority of the recommendations proposed by the Bank Auditing and Accounting Report from February 2010. According to this, regulators should consider all the risks that may arise not only in large financial institutions, but also through interactions and interconnectedness among institutions of all sizes. Any international standards should be implemented consistently so that competitive issues and regulatory arbitrage are avoided. International prudential frameworks for minimum capital adequacy should cover all the individual sectors, reducing regulatory arbitrage across countries and facilitating the supervision of cross-border groups. The BCBS, IOSCO, and IAIS should cooperate to develop common cross-sectoral standards, where appropriate, allowing for similar rules and standards to be applied to similar activities.
Policymakers should guarantee that all financial groups are subject to supervision and regulation that captures the full spectrum of their activities and risks. Mortgage originators should be forced to adopt minimum underwriting standards that focus on an accurate assessment of each borrower's capacity to repay the obligation in a reasonable period of time and the adopted standards should be published and accessible to all interested parties. Greater transparency for both credit default swaps and financial guarantee insurance should be enforced by supervisors and these should not only work closely together to foster information sharing, but should also review prudential requirements for credit default swap market information and regulatory issues. Greater standardization of credit default swaps should be encouraged and dialogue among superviosrs of central counterparties regarding applicable standards and oversight mechanisms for central counterparties should be encouraged. Last but not least, policymakers should clarify the position of financial guarantee insurance in order to ensure that the provision of financial guarantee insurance is subject to supervision and is captured by regulation.

Beardsley, Scott C., Luis Enriquez, and Robin Nuttall. "Managing Regulation in a New Era - McKinsey Quarterly - Strategy - Strategic Thinking." McKinsey Quarterly Dec. 2008. Articles by McKinsey Quarterly: Online Business Journal of McKinsey & Company. Business Management Strategy - Corporate Strategy - Global Business Strategy. Web. 01 Oct. 2010.

Benjamin, Matthew, and Harper Christine. "Volcker Urges Dividing Investment, Commercial Banks (Update1) - Bloomberg." Bloomberg - Business & Financial News, Breaking News Headlines. 6 Mar. 2009. Web. 01 Oct. 2010. .

Butler, Patric. "Learning from Financial Regulation's Mistakes - McKinsey Quarterly - Public Sector - Government Regulation." McKinsey Quarterly June 2009. Articles by McKinsey Quarterly: Online Business Journal of McKinsey & Company. Business Management Strategy - Corporate Strategy - Global Business Strategy. Web. 01 Oct. 2010. .

"IOSCO Publishes Principles For Hedge Funds Regulation." Mondo Visione Worldwide Exchange Intelligence. 22 June 2009. Web. 01 Oct. 2010. .

Krugman, Paul. "Too Big to Fail FAIL - NYTimes.com." Economics and Politics - Paul Krugman Blog - NYTimes.com. 18 June 2009. Web. 01 Oct. 2010. .

"OPINION: Financial regulation: More questions than answers. " Businessline 31 Jul 2010: ABI/INFORM Trade & Industry, ProQuest. Web. 1 Oct. 2010.

"Plenty of Time for Banks to Get It Wrong Again. " Wall Street Journal (Online) 13 Sep. 2010,Wall Street Journal, ProQuest. Web. 1 Oct. 2010.

"Report Examines Gaps in Financial Regulation Across Banking, Securities, and Insurance Sectors. " Bank Auditing and Accounting Report 1 Feb. 2010: Accounting & Tax Periodicals, ProQuest. Web. 1 Oct. 2010.

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