Regulatory wrinkles

Regulatory wrinkles
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First Published: Mon, Jun 22 2009. 08 32 PM IST
Updated: Mon, Jun 22 2009. 08 32 PM IST
The US government’s proposals for financial sector reforms were released last week. Barring giving powers to the Federal Reserve to regulate systemically important institutions even if they were not commercial banks, the proposals do not appear to go far enough. It is silent on the issues of conflicts of interest in many areas. One is concerning rating agencies. Those who seek good ratings pay for it. Plus, they shop around for ratings. Further, credit-rating agencies have a macroprudential role, given the nature of their tasks. The government should harness the information they possess while regulating their role in creating systemic risk. Second, there is a revolving door between regulators and Wall Street. There are no “cooling off” periods and no moratorium on someone moving from the government to Wall Street and back. Directly or indirectly, such easy revolving doors advance the cause of regulatory capture of the government by Wall Street.
Nor are there any concrete proposals on executive compensation. Excessive compensation was not about absolute dollar amounts, but about the lack of adjustment for risk. If the risks in the bets paid off, those who took the risk are paid. If the risks result in losses, the enterprise (shareholders) and even worse, taxpayers bear the losses. The white paper does not have much to say on it.
In India, the Reserve Bank of India solved the problem neatly in one particular instance. The central bank allowed for profits from securitization to be realized only at the end of the life of the special purpose vehicle rather than at inception. So, if anything goes wrong as happened in the case of securitization of subprime mortgages, then no profits are reckoned nor bonuses paid. It is good to note that the US government’s proposals explicitly embrace this approach in its proposal to reform securitization practices.
In the past, there has been asymmetry in the apportioning of losses or the cost of bailouts between the internal stakeholders (shareholder and lenders) and external shareholders (taxpayers). Hence, transparent guidelines for loss apportionment are both intrinsically desirable and would increase stakeholder oversight on bank management.
It is clear that by plugging the exceptions to the regulation of entities that engage in “banking” type activities without choosing to be bank holding companies, the US government has taken a major step forward in eliminating regulatory arbitrage. The administration has signalled the importance it attaches to consumer protection through the number of pages it devotes to the proposed Consumer Finance Protection Agency. In the final analysis, legislation is to be enacted by the US Congress and it remains to be seen in what form and shape these proposals emerge as laws.
In contrast, two European Central bankers engaged in plainspeaking and floated practical suggestions last week. There were many common elements between the speeches of Merwyn King, governor of the Bank of England, at the annual Mansion House dinner and that of Philip Hildebrand, vice-chairman of the Governing Board of the Swiss National Bank (SNB). Both are, well, worth a read.
King said that it simply was not sensible to provide guarantees to banks that combined high-street retail banking with risky investment banking and funding strategies. Something had to give.
Hildebrand was more direct. Apart from stricter rules for systemically important financial institutions, SNB was considering two other specific measures. One, to facilitate the winding down of large, international institutions and two, direct and indirect measures to limit bank sizes. He noted that, while SNB appreciated the advantages of size, empirical evidence suggested that the institutions had long ago exceeded the size needed to make full use of these advantages. He said that there could be no more taboos on measures to be considered, given the experience of the last two years.
King said that privately owned and managed institutions that were too big to fail sat oddly with a market economy. King observed that risks associated with large-scale proprietary trading were harder to control in limited liability companies. He was noting—perhaps with too much subtlety—the asymmetry between the sharing of rewards and losses to proprietary risk taking. If investment banks were partnerships, they would not have clamoured for additional leverage rights from their regulator, the Securities and Exchange Commission in the US,?in 2004.
In the final analysis, the worry about US’ proposals is that they do not fully address the underlying causes of banks’ bloated assets. That lacuna would cripple banks from discharging their financial intermediation responsibilities in the future, thus putting at risk global recovery hopes. In his speech, King pointed out that stress tests designed to assess the viability of banks were very different from tests of the capacity of the banking system to finance a recovery.
It would be an irony if banks, that brought the world economy to the edge of collapse with their risk-seeking behaviour, were to precipitate another collapse through excessive caution.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at baretalk@livemint.com
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First Published: Mon, Jun 22 2009. 08 32 PM IST