These are my comments on the Report from Group of Thirty I presume it will have a big impact on the new financial framework on legislation and regulation.
The report is not focusing on saving the ailing banks as the sole purpose of the new regulation. It actually shows a good understanding of why bubbles occur. We need to adapt regulation to the human nature. Humans do want to follow; if everyone is buying it takes a strong mind to sell and vice versa. Follow the winning team is human nature. We do not want to counter the prevailing trend. It is a fact and no regulation, legislation, not even taxes, can change it. The need to belong and adhere to a social group is strong and legislators need to accept that fact. The Basel Framework did not instead it actually tried to avoid banks defaulting! How could that ever be achievable? The Group of Thirty accepts that banks will continue to default and instead aims to limit the negative effects on the financial systems when they do.
Shortcomings on the Framework for Financial Stability:
No discussions on the consequences of increased protectionism forced on to the banks from supporting governments. Global bank strategies are being replaced by local strategies. Consequences for corporates:
- It is limiting the funding pool when most corporates are confined only to borrow from local banks and the depth of international securities markets has decreased
- Pan-European cash management solutions are decreasing in popularity from the banks. Many are partly pulling out of that market, especially if the corporate is not headquartered in the same country or region as the bank. This creates even more funding requirements by the corporates since they loose the netting effects from zero-balancing
- Maybe it is better that we build up a system similar to the IMF rescuing emerging markets. Why not consider the central banks supporting the World Bank/IMF to rescue the banks, deleting the direct connections in today’s bank rescues? The political leaders’ talk of avoiding protectionism is hollow since they make the banks spread it throughout the society
No discussion on the default of the twin engine of the financial markets. What new funding pools shall replace the faltering securities markets, the hedge, private equity and venture capital funds? The Basel II framework still puts a very high price on capital for the banks to lend directly to the corporates. The Basel II framework has to be drastically revised if the banks shall take over the funding of all corporates. Frankly the banks will not be able to do that under Basel II and I’m surprised this was not more clearly discussed in the report. Pouring liquidity over the banks will not automatically spill over to the corporate sector, there’s no chance of that happening.
What surprises me most though is the total lack of discussion on the dysfunctional payment system that ties up enormous amounts of cash for the corporates, public sector and individuals. One action the Bank of International Settlements should do is to create a global payment’s standard and enforce near real-time payments for all payments globally. Why the Group of Thirty missed this low hanging fruit surprises me.
My overall conclusion is that the Group of Thirty has drastically improved the understanding in relation to its predecessors of human nature and how the corporate world functions. But they still have a long way to go. There is a risk the new regulation will have large defects since they do not take the corporate perspective. It is sad that there are so few from the corporate sector included in the analysis and the decision making.
Extracts I like from the Report:
- Like the Shadow Committees criticizing the Basel Framework a few years back the Group of Thirty now also suggests that even large financial institutions should be able to be wound up: “A system with more robust failure resolution regime, having the practical capacity to permit orderly closings of large financial institutions and the administration of safety net resources in a manner that reinforces discipline on managers, shareholders, and sophisticated creditors.”
- The purpose of regulation: “Regulation and supervision cannot and should not pursue an objective of zero failures even among the largest players (read Financial Institutions). The primary aim of prudential regulation is to maintain the health of the systems as a whole and contain systemic risk.” Does this mean revising Basel II?
- They open up to the public sector to avoid “accounting, regulatory, or other practices that may inadvertently reinforce recurrent tendencies toward excessive exuberance or risk aversion.” Bye, bye worst effects of Fair Value? “In sum, the accounting principles and approaches applicable to regulated financial institutions whose primary purpose is to intermediate credit and liquidity risk needs to be better aligned with the firm’s business model. A pure mark-to-market accounting model is generally preferred for trading activities and most elements of market risk.”
- Obviously they open up for regulation of hedge funds et al.
- Ways of improving the quality and effectiveness of prudential regulation and supervision: “There is, however, an emerging consensus around a number of key points, including: (a) the need to substantially simplify and consolidate overly complex structures; (b) the emphasis on clarifying and stressing guiding principles of regulation rather than a rules-based approach to regulation; (c) the importance for much greater levels of international cooperation and coordination on such matters as accounting standards, listing standards, licenses to operate as regulated firms, supervisory oversight mechanisms, and, most important, prudential capital and liquidity standards; (d) the importance of regulatory arrangements having the flexibility to adapt to new types of institutions, instruments, and markets; and (e) the need to ensure the political and market independence of national regulatory authorities. Finally, there is a growing appreciation of the importance of ensuring that central bank responsibility for promoting financial stability is supported by adequate authority and capacity.”
- Managing the cycles and the role of the central banks: “Recent events provide impetus for recognizing a financial stability role for central banks.” And: “Another is how best to combat the development of financial excesses before they build into full-fledged crises. More countercyclical regulatory and supervisory policies are one such tool. Consideration of asset market developments in setting monetary policies has been a controversial but important debate.” And: “To the extent that excessive use of leverage is a recurring significant contribution to potential financial instability, central banks may consider the value of employing countercyclical tools that work directly to avoid excesses.”
- They see the lack of relationship based banking participated in creating the crisis: “The primary factors contributing to this loss of confidence have been the excessive complexity of these instruments and the lack of transparency that has characterized these markets. An additional contributing factor has been flaws exposed in the workings of the “originate-to-distribute” business model followed in the capital market units of virtually all large banking organizations. Those flaws include: (a) an erosion in credit underwriting standards, based on a transaction rather than a relationship and retention approach to credit risk;…”
- Expect changes for the Credit Rating Agencies: “Unfortunately, however, the economic model that supports the rating agencies is driven not by these users but by issuers who select and pay for the ratings.” And: “In addition, the rating agencies are not held legally accountable for the quality of their work.”
