DESIGNING GLOBAL FINANCIAL REGULATORY INSTRUMENTS
Despite the largest financial crisis since the 1930s, progress towards international coordination of financial regulation remains dismally slow.
To speed the development of a harmonized regulatory framework, policymakers need to focus on international rules for financial instruments, rather than just financial institutions.
To date, most regulation addresses the risks of individual institutions, rather than collective or systemic risks. Where broader issues have gained attention, it has focused on large, complex financial institutions that are deemed systemically important from a domestic perspective.
Yet, these systemically important financial institutions (SIFIs) operate across borders. And differences in regulatory styles and interests across countries slow international coordination.
Worse, the focus on SIFIs likely will shift risk-taking over time to the weakly regulated or unregulated shadow banks.
How can the regulation of financial instruments address these problems?
The point is to regulate any intermediary—whether it is viewed as systemic or not in different countries— that holds systemic instruments.
Examples of systemic liabilities include demand deposits, repos and over-the-counter derivatives. When a counterparty’s default results in losses, these instruments can trigger runs on other intermediaries.
Systemic assets are usually illiquid, high-risk instruments that are financed by systemic liabilities. Fire sales of such illiquid assets inflict indirect damage on other asset holders as prices plunge. Examples include the use of asset and mortgage-backed securities as collateral for commercial paper or repurchase agreements (repos).
How could one effectively regulate such systemic instruments?
To do so requires the establishment of dedicated financial utilities, such as the emerging clearing houses for derivatives.
These utilities—think of a repo clearing house—would address defaults by ensuring the orderly liquidation of positions. Because such liquidation poses significant risks, a clearing house utility would have incentive to impose limits on the risk of positions by its members. A variety of tools could be used, including upfront margins, variation margins (based on changes in market values), outright position limits, and in extreme cases, imposing circuit-breakers.
As an example of this regulatory approach, we proposed at a recent Federal Reserve conference the establishment of a repo resolution authority (RRA) for the resolution of systemic instruments underlying the repo market.
You can think of the RRA as a clearinghouse for repo contracts.
In a crisis, the RRA can suspend the automatic liquidation of collateral underlying repo claims.
Instead, the RRA assumes the liquidation rights while ensuring provision of liquidity to the market sufficient to avoid insolvency concerns.
In good times, the RRA imposes participation criteria and haircuts on repo financiers, who would pass on the relevant costs to borrowers in the repo markets.
Repo backed by ineligible collateral would remain outside of the liquidity enhancement provided by the RRA. These contracts would be relatively subordinated in the capital structure of financial firms. Regulators could subject them to prudential capital requirements, minimum haircuts or over-collateralization requirements.
Implementing this regulatory approach internationally would be far easier than coordinating the regulation of individual institutions with a multitude of legal forms. For example, the Financial Stability Board—the regulatory arm of the Group of Twenty countries or G-20—can coordinate at the global level the establishment of utilities like the RRA and enforce their risk-management standards.
To be sure, new potentially systemic instruments would arise over time. If and when they mature, regulators would need to introduce new designated utilities.
Why do we need to act now?
In the heyday of the Great Financial Crisis, the leading central banks set up many liquidity facilities to halt a total financial collapse. These facilities invariably were devoted to financing of systemic instruments. Stated differently, the crisis compelled central banks and regulators around the globe to support systemic instruments, not just the intermediaries holding them.
To avoid an eventual repeat of these emergency actions, we must build the essential infrastructure for systemic instruments to contain excessive risk-taking and facilitate orderly crisis resolution.