Thursday, April 23, 2009

Towards a new system of financial regulation

by Philip Whyte

The financial crisis is often portrayed as the product of weak regulation in the Anglosphere. But it is more accurate to think of it as the result of flawed thinking (and policy) across the global financial system as a whole. One reason is that countries outside the Anglosphere have also experienced unsustainable credit and housing market booms. Another is that differences in regulatory systems are smaller than is often supposed. The lesson of the crisis is not, as Nicolas Sarkozy and Jean-Claude Juncker seem to think, that Anglo-Saxons must move in a European direction. It is that all countries must converge on a new regulatory model.

It is not hard to see why the attention of European politicians should have zeroed in on regulatory flaws in the US – it is, after all, where the financial crisis broke out. There are unquestionably important lessons to be learned from the US experience – particularly in relation to the ‘shadow banking system’ and securitisation (the process of originating loans, then packaging them up as securities and selling them on to the market). But the financial crisis has done more than simply expose flaws in the US’s regulatory model. It has also called into question the very principles on which institutions the world over have been supervised.

The first flaw that the crisis has exposed is the ‘pro-cyclicality’ of financial regulation. Regulation did nothing to mitigate the expansion of leverage, credit and house prices. Capital adequacy rules did not become more constraining during the upswing, while accountancy rules exacerbated the downswing by forcing firms to sell assets at distressed prices. So the regulatory framework did not provide enough of a check on banks at the top of the credit cycle – but compounded their problems when the cycle turned. Lesson: the regulatory framework must be redesigned so that it mitigates, rather than exacerbates, the credit cycle.

A second problem brought to light by the crisis is that regulators were not paying enough attention to liquidity. For the past twenty years or so, international discussions between regulators have concentrated overwhelmingly on solvency – that is, how much capital financial institutions should hold to cushion themselves against losses on their banking and trading books. But many of the institutions that were brought low by the crisis (such as Northern Rock and Lehman Brothers) ran into trouble because their sources of funding dried up. In effect, regulators had spent the past twenty years preparing for a right hook, but ended up being floored by an upper cut. Liquidity will loom larger in regulation than it has done to date.

A final flaw that the crisis exposed is the belief that the stability of a financial system follows inexorably from the soundness of its individual constituents. What this belief ignored was that institutions were more interconnected (and hence vulnerable) than was previously realised; and that actions by individual institutions to maintain their own stability could, when copied by all their peers, push the system itself to collapse. In short, regulatory regimes paid too much attention to the supervision of individual institutions (micro-prudential regulation) and not enough to the system as a whole (macro-prudential regulation). Macro-prudential supervision will be one of the key innovations to emerge from the crisis.

A major overhaul of financial regulation is in prospect, both in the Anglosphere and Europe. It will not involve the supposedly unregulated Anglo-Saxon systems converging on existing European models, but Anglo-Saxon and European models converging on an entirely new model, with novel rules and institutional structures. Will the new system regulate future crises out of existence? Almost certainly not. Financial systems will always be prone to periodic crises because of the nature of their function – borrowing short and lending long – and because they rely on fickle human traits such as confidence and trust. But if the new system can limit the scale of future crises, it will have done its job.

Philip Whyte is a senior research fellow at the Centre for European Reform.

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