Financial reform and regulation:
Progress on G20 agenda
Aniket Bhushan
The North-South Institute
Outline
• Understanding financial market failure and
crisis
• Principles underlying reform & regulatory
change
• Key reforms, institutions and status
• Conclusions
• Core: reform areas central to the crisis
• Periphery (1): issues related to core crisis
• Periphery (2): issues seen as important, but
not directly related to crisis (i.e. crisis
opportunity to affect wider changes)
If we had this would we have avoided the crisis
or mitigated impact?
Understanding financial failure
• Originate-to-distribute model: complex derivatives, but
simple maturity mismatches
• Leverage and deleveraging cycle (Minsky-moment)
• Contagion cycle: financial  real  political
• Contagion: liquidity  solvency
Amplifiers
• Endogenous risk (behavioural)
• Counterparty risks
• Off-balance sheet, contingent lines - paradox of trust
• Excess reliance on ‘wholesale’ finance
Broad principles underlying reform
and regulatory change
Core (well-accepted)
• Undercapitalized financial system
• Limits of micro-prudential (individual) rationality in regulation,
supervision
• Limit size, complexity, in some cases interconnectivity of financial
inst.
• Mother-in-law theory of risk allocation
• Ex-ante incentives (bail-in) vs. ex-post (bail-out, levy, taxes)
• Continuous markets (risk pricing, market clearing, basic
transformation functions – ‘market-maker of last resort’)
Peripheral (debated, less accepted)
• Economics vs. finance paradigm: scarce liquidity vs. price
discontinuity
• Limits of fundamentalist efficient-markets paradigm (friction, noise,
momentum, info asymmetry)
• Monetary system (different from financial) broken
Principles and outcomes
Outcomes: 150+ specific G20 commitments, unprecedented at
global level
• Financial re-regulation (leverage, capital, new tools)
• TBTF measures & limits
• State/authorities as risk absorber of last resort (fiscal costs)
Ifs and Buts
• Immense coordination, practical implementation challenges
• No real broad re-think, within finance-centric paradigm, no
clear alt/challenge
• Superficial allusions – ‘socially optimal/responsible financial
system’; finance and econ development, sustainable growth;
almost no link with poverty reduction
Fiscal Cost
Where you stand, depends where you sit ($, billions)
G20 Advanced
Emerging
3530
2400
1220
756
639
90
capital injection
461
38.4
used
18
purchase
lending
(treasury)
5
used
0
purchase
lending (CB)
7
guarantees
Reforms, institutions, status: Core
Basel III, BCBS, CGFS, CBRG
• Capital standards, common definition (Tier 1), higher standards (e.g.
TCE). Adequacy ratio: min capital requirements
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High quality cap (common equity) very low bar (2% of risk-w-a);
New LCR (liq. Coverage ratio), NSFR (net stable funding ratio)
CE and Retained Earning in Tier 1 will rise
Contingent capital
New leverage ratio (as backstop)
New rules on off-balance exposure (higher RW for securitization)
New trading book rules
Countercyclical buffers and forward looking provisioning
Incentivising centralized counterparties; higher cap req. for intrafinancial sector (Com Payment Systems)
• Cross-border bank resolution (CBRG, FSB, IMF-WB)
Core issues (cont.)
• Progress on new trading book rules (Summer 2009)
• Cap standards, adequacy: major consultation paper
(Dec, 2009); final by Korea Nov 2010(?);
Implementation aimed by 2012; but could 2014-16
• Limited on others (esp. new tools, counter-cyclical
buffers)
• Banking push back: damaging for recovery (IIF)
• Major coordination challenges (BCBS-FSB)
Remember: global standards are lowest common, most
countries have higher national (Pillars 1, 2 and 3)
Banks already raising capital
Core issues (cont.)
Financial Stability Board (FSB)
• Recently expanded (G10 -20); main
coordinating body (all major national reg. 24
countries, BIS, ECB, EC, IMF, WB, OECD, Basel
committees, IAIS, IASB, IOSCO)
• 12 key Standards for Sound Fin Sys (macro
transparency, market infra, reg and
supervision)
Core
FSB coordinated (cont.)
• Coordination, esp TBTF (capital, leverage, liquidity, firm
structure, cross-border resolution, fin infra)
• Compensation: consultation published March 2010, major
differences, implementation review Q2/2011
– Similar IAIS for insurance; IOSCO for investor risk
• SIFI implementation progress (FSB report Apr 2010): interim
report June 2010 G20, final recommendations Nov G20
– IMF/FSB/BIS systemic importance paper: Oct 2009, progress report
by Jun 2010
– FSB Cross-border resolution WG: Oct 2010; IMF studying legal
• OTC derivatives to central counterparty (CCP): CPSS, IOSCO, EC,
FSB working group, interim policy paper Oct 2010 and early
2011
Core
Accounting Standards
• Harmonization of IASB (IFRS) and FASB (US-GAAP)
– Derivatives under IFRS (Euro) make balance-sheets
much larger than US-GAAP
– EU proposed review of mark-t-market; off-balance
sheet etc.
• Cost and fair value accounting
• Target completion June 2011 (likely much delay)
• Outstanding: change in composition of IASB, less
accounting profession rep
Core
Macro prudential oversight and systemic risks
• Covers much of terrain already discussed
• FSB progress report June 2010
• CGFS-FSB key: SIFI, systemic leverage, capital, OTC
derivatives
• IMF/FSB: early warning exercise
• Data gaps report: Nov 2010
• Systemic liquidity risk: BCBS-CGFS (May, 2010)
• Systemic risk insurance sector: IAIS (2013)
Core
Credit Default Swaps (CDS)
• Buying insurance on neighbour's house and
burning it?
• Diff perspective: most liquid instrument ($5560trillion), trading even when everything froze
• Not transparent, lot of myths (‘naked shorts’);
very small no. market makers –easy pol. target
• But authorities willingly allowed this market to
grow without oversight: 1tr (2001) -57tr (2008)
Core
CDS and other OTC derivatives cont.
• CCP: more transparency, price, vol, spread
disclosures; trading limits
• State of play: CCP’s introduced in US and
Europe (2009); studies in Canada, China,
Japan, Russia, S. Africa (expected 2010)
• Reg. arbitrage could emerge as major problem
as countries very much doing their own thing
(FSB)
Core
Securitization
• More loan-by-loan info on ABS, more assessment
time. Principle: increase transparency and
retention requirements
• Eurosystem collateral framework: 2010-11
• US SEC rule proposed April 2010
• BoE consultation launch March 2010
• Expect fight as pre-existing securitization practices
across countries v. diff (e.g. Canada, India)
• (Link with cap requirements already described –
see Basel-III)
Core
Rating agencies
• US: new SEC rules on national CRAs (Sep
2009); EU legislation entered into force (Dec
2009); Aus took effect (Jan 2010); Korea
(2009)
• Either studying or draft bill proposed (2010):
Canada, Japan, Mexico, S. Africa
Summary: status of core issues
High conceptual clarity
Capital adequacy; capital standards ; trading book
High/reasonable prospect (with changes; leverage ratios; liquidity ratios;
modifications)
countercyclical buffers
High level consensus
Reasonable conceptual clarity
Reasonable prospect (in some
jurisdictions more than others)
Some consensus
Charges on SIFI; other macro-prudential systemic
risk measures – FAT, FSC (IMF); Financial Crisis
Responsibility (FCR) fee (Obama-TARP levy 0.15%
of LFI liabilities); market stabilization fund
(Germany, US); bonus/payroll taxes (UK, France)
Resolution plans –living wills;
Volcker-rule
Basic concept, low clarity
Uncertain prospects
No consensus
Cross-border resolution regime- its link with
national measures (punitive charges, stability
funds); bank-tax/levy; FTT/CTT
Key national/regional developments
US: July 4 bill, sweeping reforms
• New ‘council of regulators’ to monitor systemic risk
• TBTF: mid-ground between bankruptcy and bailout
(funeral plans – orderly liquidation). Compromise
Congress/Senate
• Stabilization and resolution fund
• Volcker separation of prop trading from guaranteed inst.
– Limits on market-share, exposure to hedge funds
– Under study (2012); no support Canada, Europe
• OTC –CCPs; new securitization disclosure; GAAP
harmonization
• Consumer protection agency
Key national/regional developments
UK
• FSA closure by 2012 (criticized: too narrow rule-compliance focus
at expense of big picture)
• New powers for BoE: Financial Pol. Committee; Prudential Reg.
Authority; Consumer Protection and Market Conduct
Euro-zone (EU)
• Most far-reaching reforms -greater centralization
• New E. Systemic Risk Board; E. Banking Authority; E. Securities
Market Authority; insurance (EIOPA)
• Proposed deadline end-2010, stalled, possible 2011
• New capital requirement, derivatives directives -2011
• Corp gov. remuneration consultation Sep 2010
• Greater role for IMF (Financial Soundness Index)
EU (passport) vs. UK, US fight over hedge-fund reg
Periphery 1: core related
Monetary system (link to financial)
• Adjustment of macroeconomic imbalances and
associated ex-rate adjustment (can G20 deliver what G7
did) –key: whose pace, whose terms
• Emerging E: macro stability factors diff:
– Containing volatile capital flows and asset bubbles
– CB toolkit broader (vindicated); selective discretionary cap
controls
• Reserve accumulation vindicated
– Alternatives: IMF –FCL (Colombia, Mexico, Poland)
– CB swaps, regional swaps (C-Mai), repo lines (liq. supports)
• Peer review mechanisms –FSAP, new FSI
Periphery 2
• Tax havens (OECD-TIEA)
• Hedge funds; Dark capital pools, algo trading: taxes on
financial transactions curb speculation; CTT
– Pervasive debt-financing tax bias
• ‘Socially productive’ financial innovation
– Mandated business model (Volcker)
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Inequality as source of financial instability
New kind of (non-national currency) monetary sys
Meaningful post-crisis fiscal, monetary coordination
Countercyclical anti-shock financing limit DC/LIC
contagion
• New financing for development, climate, poverty
reduction
Conclusions (caution)
• Perimeter of regulation is political (unison in
rescue, fragmentation in reform)
• Speed, scale, sweeping nature of reform & pol
pressures pose major coordination challenges
• Stricter reg. will take effect as most G7 under
fiscal tightening pressure (2011-15)
• Next crisis will emerge from regulatory chaos
(arbitrage, contradictions), overreach, lack of
coordination
Framing interventions
• What does a responsible financial
system/sector look like?
• If new paradigm, what components?
• Rather than dramatizing “Gs” consider all are
grappling with common unknown unknows –
i.e. intervene constructive, coherent, solutions
What we have endorsed
• Getting definition of financial efficiency right
– From risk-reward to risk-social return
• Cross-border regulation weakest link
• Fin sys. key player in ‘growth with equity’
• Protection vs. protectionism
– Do not underestimate imp of systemic integrity (trust)
• Broader view of macro stability
• State as risk-absorber of last resort: proactive
reg./oversight, weathered better (Canada, Australia, India)
• Monetary adjustment mechanism (cost): preservation of
purchasing power (capital) vs. labor
– Countercyclical financing (global), institutionalizing SDR could
be part of this, as could regional/multi-swaps
Shameless self-promotion
• Widening Global Governance: Building on the G20,
Aniket Bhushan & Diana Tussie, Canadian Development
Report, 2010
• Policy Responses to Unfettered Finance, NSI, 2009
• Beyond Band-Aid Solutions, NSI, 2009
• Mapping the Market Genome: policy brief, Aniket
Bhushan & Richard Bookstaber, 2009
• Lessons from the Economic Crisis, The Mark, Jun 2010
• Undoing the Washington Consensus, The Mark, Jun 2009
• Explaining Canada’s Resilience to the Crisis: Securities
and Housing Finance, 2010