The current financial and economic crisis owes party to the outdated model of regulation where governments tried unsuccessfully to regulate a global financial industry with a nationally focused and highly fragmented regulatory system. As a consequence of this, large swathes of the financial industry hid in the ‘regulatory cracks’ and was not being supervised.
This lack of supervision was reinforced by an ideologically driven deregulation based on a misplaced faith in the ability of markets to always self correct. Furthermore, even when regulations existed, they were not applied.
It was in this poorly regulated ‘shadow financial system’ comprising SIVs, Hedge Funds and other off balance sheet exposures that the crisis originated and its intensity was reinforced by the risks hidden in ‘shadow financial products’ such as Credit Default Swaps which were also unregulated.
In order to restore faith in the financial system and to ensure that a crisis of this magnitude does not recur, it is imperative to strengthen regulations and expand their scope. All financial activity that can potentially pose a danger to the stability of the financial system and hence have a disruptive effect on the economy must be regulated and supervised.
More specifically
- Comprehensive Regulation: Regulation should be comprehensive in scope so that there is a presumption to regulate all financial institutions, all financial products and all jurisdictions to fill up the ‘regulatory cracks’ where risks be hidden from view.
- Regulate substance, not form: Regulatory and supervisory coverage should follow the principle of economic substance and function not legal form so if something ‘walks like a duck and talks like a duck it should be treated as a duck’.
- A global regulatory floor: The EU should focus its financial diplomacy efforts on pushing for a high ‘global regulatory floor’ that would apply to all jurisdictions including offshore financial centres. This push should be supported by legislation that discriminates against lower regulatory standards by withholding access to the EU market and penalizing financial dealings with such centres with higher capital requirements.
- Special and differential regulation for LDCs: Pushing for the global regulatory floor is not incompatible with providing for a special and differential treatment for LDCs and other developing countries with small and immature financial systems which do not pose a systemic risk to international finance and might not have the capacity to implement uniform standards adopted by the OECD and EU.
This would help reduce the scope of financial actors ‘gaming the system’ or engaging in ‘regulatory arbitrage’ which was central to the built of risks leading to the crisis. Too often institutions were regulated on the basis of what they said they did rather than what they actually did.
- A new ‘eagle eye’ financial stability regulator: We need a new ‘systemic regulator’ which has the capacity to have a ‘birds eye view’ of the financial system as a whole. This regulator also needs to be empowered to act to take corrective action either by itself or through national level supervisors in the EU to guard against systemic risks which threaten financial stability. This regulator would replace the current Lamfalussy Committees .While a strong empowered regulator is ideal, the idea of a European Systemic Risk Council proposed by the de Larosiere group is a second best solution.
- A stronger financial stability role for the ECB: As the purveyors of monetary policy, overseers of payments systems and lenders of last resort, central banks are in a unique position to identify and stem destabilizing developments in credit markets so the ECB should be empowered to play a much stronger prudential oversight role to help maintain financial stability.
- A global prudential regulator: As the current crisis has so starkly highlighted, systemic risk can arise from actions both inside and outside the EU common market so it is critical to have a global financial stability watchdog in order to guard against the recurrence of a financial crisis of this scale. At the very least such a regulator would oversee and co-ordinate the work of regional ‘systemic regulators’. It is possible for a significantly reformed IMF or FSF or UN to take up this mantle though there are certain advantages to setting up a completely new institution.
Having such systemic or financial stability regulators would help generate early warnings and reduce the occurrence of large financial crisis. One of the central lessons of this crisis is that having sound financial institutions is necessary but not sufficient for having a sound financial system since inter-connections between institutions are also a major source of risk.
While a global regulator would be ideal, a pan EU systemic regulator at the very least is completely indispensable. Both the global and the regional regulators would need to have high legitimacy, sufficient resources and robust independence albeit with accountability.
- New EU institutions for consumer and investor protection and market integrity: While firms should continue to be supervised at a national level, a close co-ordination of firm level or micro-prudential regulation standards is necessary both to ensure the effectiveness of system level macro regulation but also for the purpose of preventing regulatory arbitrage and providing high and common levels of investor and consumer protection which are central to the smooth functioning of the single market. The consumer protection and investor protection & market integrity roles would ideally be performed by separate EU level institutions working in close co-ordination with each other and the respective national authorities.
- A special emphasis on large cross border financial institutions: More than 70% of EU banking assets are managed by 43 large financial institutions with substantial cross border operations. The supervision of these institutions should be handled by colleges of supervisors overseen by the pan EU regulatory authorities.
Having this EU level co-ordination would help mitigate that arise when significantly different regulatory and supervision standards apply across various countries especially within the single market. Moreover having regulatory standards which are co-ordinated at the EU level and provide high minimum levels of investor and consumer protection will go a long way towards the development of a true single market.
Any exemptions need to be specifically mandated not blanket and should be renewed regularly with the possibility of roll back at any time.
Sony Kapoor
Managing Director
Re-Define