New Delhi: The University of Warwick, UK, formed a commission of academics and market practitioners to address important issues in international financial reform. The commission’s report, In praise of Unlevel Playing Fields, makes some interesting suggestions on the approach to financial regulation. Mint spoke to the commission chair, Avinash Persaud, who is also chairman of Intelligence Group—a consultancy, and Leonard Seabrooke from the University of Warwick, who was a member of the commission. Edited excerpts:
Objective view: (left) Leonard Seabrooke and Avinash Persaud say that often where governments don’t want to spend the money, they do welfare on the cheap through the banking system, thus creating a crisis. Ramesh Pathania / Mint
When one takes a bird’s eye view of the way you have approached regulation, you have said it is better to focus on behaviour in the financial system rather than institutions and instruments. Take us through this approach.
Avinash Persaud: Well, there are two or three reasons why we ended with that view. One is that many politicians and the public have a mistaken view about financial products—that they are singular tangible things. In reality, the process of developing products is fluid. It is a little bit like a river flowing. You can throw a couple of pebbles in the water and say you can’t go into that particular spot in the river and all that will happen is that the river will flow around it.
The second point is that risk is not a singular thing. The risk of an instrument depends on who is holding the instrument, not inherent in the instrument. The notion that there is such a thing as risky instrument in our view is really very partial. We don’t care what instrument people are using to double up on their leverage, that is the behaviour we want to deal with. Leverage is a good example. Leverage is the way the financial system becomes risky in a boom. But there are many, many ways in which you can do leverage, through products, through behaviour. We think it is important to focus on behaviour, which is actually quite stable and simple as opposed to instruments, which are complicated fluid and multidimensional.
In the area of macroregulation, you suggested regulators stick to a rules-based regulation in a boom. Politicians are not going to like that.
Booms occur because people believe it is different this time around, something has occurred, which makes the world a safe place. We believe you need to reduce some of that discretion in a boom. There is no simple rule and the Spanish had a rule for a while based on the rate of credit growth. We think it is practically possible, but really it is about how to address the politics of a boom.
As part of the unlevel playing field, you have asked for systemically important financial conglomerates to be treated in a different way. Doesn’t that lead to a discretionary approach to regulation?
Yes, and the big banks have been successful at trying to persuade that level playing fields are good. But we feel that finance is different from regulating the gas industry. One has to think about managing risk systemically. It makes sense to discriminate. It makes sense to treat an institution where, were it to fail, it will bring down the entire financial system differently from another institution whose failure would not.
The other point you have made is incentivize risk to flow to places where they are best hedged. What sort of incentives do you have in mind?
The one thing you could do that deals with this 80% would be to think about funding. Because the difference we have in the financial system relates a lot to different capacities to fund instruments. So, insurance companies and pension funds because of their long-term liabilities are able to have a capacity to hold illiquid assets. A bank with its short-term deposit taking does not have that capacity. The banks have convinced regulators we don’t need to worry about that, we can use statistical measures of the maturity of their funding and maturity of their assets. Our view is, in a world where risk, ex ante, is hard to identify, you have to be less reliant on these statistical measures and more reliant on structural capacity. So a simple rule would be that we would actually require institutions to put aside extra capital if there is a mismatch in the maturity of their funding. This will tilt the playing filed for illiquid assets towards institutions that can afford to hang on to an asset. Those illiquid assets will flow to those institutions because they will be cheaper, they will have less maturity mismatch. A bank would have to pay extra capital for holding an illiquid asset, and that will push those assets away from them.
The essence of your suggestion would be to use capital requirements to nudge risk to an institution that is best placed to hold them.
It’s right. We are conscious that we are using one tool. There is a limit to what capital can do.
What are the other tools?
We couldn’t think of any. We are conscious that we are giving a big role to capital.
Given your track record—you have worked with JPMorgan and UBS— won’t some of the suggestions run counter to what your former colleagues would believe?
You find that odd? Let me turn the question around. Where should the countervailing force of ideas be in a financial system?
We know there is going to be regulatory capture. It would be very odd for industry to not to try and influence the regulators. Every industry does.
Regulatory capture is more important in finance because it is a very powerful industry. The consequences are more important because this regulatory capture has created a type of regulation that is systemically dangerous.
So to me the interesting question is, why did academia not play a stronger countervailing force? Why did the press not play a stronger countervailing force? It is interesting to me that the press was not a countervailing force, partly because where does the advertising come from. The academia...where does the funding for research come from?
I think there were more people in finance saying there was a problem than there were in academia.
Leonard Seabrooke: If you want to be an academic and join economics then you have to have a certain style of economics. That kind of group think is a real danger.
“The locus of much banking regulation needs to be national.” By saying that, don’t you run counter to the current trend of being mindful of the dangers of protectionism?
It’s risk. I find the debate on it quite interesting because we have had global regulation in banking. Many people come into this debate without the background of what we have been doing, saying we must have global regulation because otherwise there will be arbitrage. In fact, we have had arbitrage because of the practice of the type of global regulation we have had, which is, you have a home country regulator. But the home countries, especially in large financial centres, have played the role of the national champion of their local banks. And they have treated them preferentially and encouraged them to go abroad, maybe thinking this was spreading the risk away from them.
Two examples of that would be Iceland and London where the regulator signed up to global rule, but proudly proclaimed, in the case of the UK, to light touch regulations which would deliberately be supportive to banks. So, global regulation, with different types of enforcement was a major source of arbitrage. Let us take the example of Switzerland and Hungary. Hungarians got into trouble by borrowing Swiss franc mortgages. Do we rely on the Swiss regulator to stop their banks lending Hungarians Swiss franc mortgages when in fact that probably does nothing to Swiss banks’ wellbeing? But it is a huge risk to the Hungarian economy.
We argue the way to deal with that problem is to empower the Hungarian authorities with the way they regulate. At the end of the day, that will be a greater limit to regulatory arbitrage than the practice if not the concept of global regulation.
The commission recommends government use direct intervention instead of using banks to pursue social policy. Take the case of small enterprises, what if there is market failure to help them access credit. What kind of direct intervention can government use, wouldn’t using banks make sense?
Often where governments don’t want to spend the money, they do welfare on the cheap by the banking system. We have to be very careful about that where it can create a crisis. Generally, we are nervous about governments doing welfare on the cheap through the banking system.
I think it is too easy for governments to say there is a market failure. What is causing the market failure? In the case of finance, the reason why banks don’t lend to small accounts is cost of credit monitoring. If you force people to do something where they are not doing cost of credit monitoring, you are not solving a problem, you are creating a credit monitoring (problem). There may be ways the government can solve the credit monitoring problem.
We would say you should separate regulation, which is about identifying the risks of banking, from financial policy, which may be supporting certain people you want to support. You shouldn’t do that in a way that pretends risk is not there.