If there is any consolation in the latest credit crisis, it is the vigorous global debate now unfolding on regulatory reform. Regulators and market participants see an opportunity to reassess, and to get organized around guiding principles that can help financial institutions and financial markets handle the mounting complexities of global trends in business, markets and the economy.
In my view, three principles in particular — transparency, a level playing field and systemic oversight — are the essential elements we need to consider as we look at how best to frame these reform discussions. The goal of the debate should be to advance global coordination among central banks, regulators and financial institutions in ways that increase our understanding and ability to manage systemic risk.
Markets cannot clear without transparency. We all know that and, yet, we’re seeing again the consequences of a lack of full transparency. Fixed-income and credit markets currently are among the most opaque markets. Transparency concerns can lead to illiquidity.
Yet, transparency is difficult to achieve. It requires continual vigilance to standardize products when appropriate, introducing them to exchanges, creating counterparty clearinghouses and settlement systems and, finally, amassing accurate data on prices and transaction volumes. Transparency must also include public disclosures to investors about pertinent risk and financial information which give the market a chance to make informed judgements.
Moreover, transparency means that systemically significant institutions — essentially any institution whose uncontrolled failure would impact the financial system in a significantly adverse way — should meet robust information requirements set by the overseeing regulatory agency.
The next principle is a level playing field, which includes two distinct issues: standards and capital requirements. Rating agencies, independent monitoring entities and risk bureaus are all important if accredited correctly. Global coherence and consistency on accounting standards can also help, including clear guidelines regarding off-balance-sheet instruments.
In recent dysfunctional markets, we have seen different accounting standards applied which were based on an institution’s form and regulatory jurisdiction. Accounting based on a mark-to-model has been severely tested by unobservable inputs intended to estimate the market. This has fed into difficult, far-reaching decisions that impacted capital and other factors as one misinformed trade set off a chain of similar trades. This raises an important question: Are there alternative accounting approaches we should apply, particularly in dysfunctional markets?
We also need consistent capital requirements for systemically significant institutions. As we consider how to define a level playing field, we ought to ask what now constitutes a “financial institution”.
When judging which institutions should be allowed access to the playing field, focusing on function, rather than form, seems a sensible answer. Financial services and parallel banking activities in many ways are becoming ubiquitous and, to some extent, interchangeable.
The third suggested principle is a need for oversight for systemically significant institutions. We cannot and should not legislate away an institution’s ability to lose shareholders’ money. But none should have the right to impose externalities on the rest of the financial system. Does an institution warehouse risk? Does it borrow short and lend long? Does it leverage its investments? Once a company gets large enough to impact the financial system, shouldn’t it operate under the same systemic risk umbrella in terms of capital, liquidity and transparency?
In the US, we recently saw the unprecedented opening of the Federal Reserve discount window to non-banks. By definition, unprecedented events set a precedent. And regardless of whether that window is officially opened or closed, the market now assumes that it will be open if necessary on an ad hoc basis.
Capital and liquidity speak for themselves.
Systemically significant institutions need to be as transparent to regulators as regulated institutions are. Without this level playing field, regulators charged with safeguarding the world’s financial systems simply won’t have enough information to mitigate systemic risk.
An uneven application of regulations and accounting standards in an environment where capital and talent are mobile and where traditional classifications are being redefined has the potential to increase systemic risk. Applying rules partially is not the second best option to applying them consistently.
In order to realize all the possibilities in the global trends reshaping our world and our financial systems, we welcome a more robust regulatory architecture that embraces standards broad and clear enough to apply to all participants, but is flexible enough to be adaptable to unforeseeable changes in a dynamic market.
THE WALL STREET JOURNAL
Vikram Pandit is CEO of Citigroup. Comment at firstname.lastname@example.org