Issues in Global Financial Regulation

1. Issues in Global Financial Regulation Paul Wright Institute of International Finance Washington DC April 5 2011

2. Regulation? • Prudential regulation (eg of banks, insurers) • Understanding risks run by firms • Adequacy of governance, management, controls • Adequacy of financial resources • NB risks may be firm-specific or to the system as a whole (‘systemic’ risk) • Not the same as business conduct or consumer protection regulation • NB ‘regulation’ is about setting rules, ‘supervision’ is about assessing compliance and wider risk assessment • Still quite fragmented in US (Fed, OCC, FDIC, States, SEC, CFTC)

3. Introduction • Regulation in several countries in the years leading up to the crisis was predicated on a number of assumptions that were flawed: • Self-correcting/regulating quality of markets • Scope for placing trust in senior management • Managements and boards broadly shared the objectives of regulators • Proportionate, market friendly regulation encouraged innovation and growth • Risks existed but were containable and occasional instability was a price worth paying for a vibrant financial system • All of these have been challenged • The most ‘market friendly’ jurisdictions are now among the most hawkish

4. Overview • Five ‘pillars’ to regulatory reform: • Regulation (capital and liquidity) • Resolution – including systemically important firms (SIFIs) • Supervision • Macro-prudential • Industry practices • All of these are important and progress is necessary with all of them. The current debate is too focused on regulation and resolution and is increasingly unbalanced • Without a proper balance regulation will be ineffective and will have huge economic costs (short and long run)

5. Regulation (1) • The core of the reform agenda • Basel Committee (BCBS) is putting in place new rules on capital and liquidity • NB ‘capital’ is about basic solvency; ‘liquidity’ about being able to make payments on time • Effect is to increase common equity requirements from 2% to 7% • Also additional buffers and maybe a systemic surcharge • Also new rules on liquidity (which the industry find formulaic and contrary to sound risk management)

6. Regulation (2) • New/tougher regulation is clearly needed • But the economic impact needs to be carefully considered • IIF June 2010 findings: • Global banks would need to raise $ 0.7 trillion of common equity • Plus $5 trillion of long term wholesale funding by 2015 • G3 GDP would be 3% lower by 2015 • G3 employment would be 9.7 million lower by 2015 • Official estimates (of impact) are much lower • Much comes down to how available capital is and on what terms • Also risks of fragmented implementation and driving business out of regulated sectors

7. Supervision • Relatively overlooked in until recently • Regulation = setting rules • Supervision = assessing compliance + identifying broader risks • Need to reassess supervision • Rules vs outcomes • ‘Intrusiveness’ of supervision • What is required of firms • How to make it work globally • Critical issue: • Bit of a tendency up to now to ‘give up’ on supervision, partly because supervisors are human and fallible. Can’t be the right answer

8. Resolution (aka Too Big to Fail) • Firms must be able to exit the market without systemic disturbance or use of public money to avoid this • Complex issue: • Globally coordinated resolution schemes • Firms’ recovery and resolution plans • ‘Loss absorbency’ • Capital surcharges • Contingent capital • ‘Bail-in’ • Critical issues: • Issues are complex and inter-dependent • Can regulators agree on how to make global firms safer? If not, make them less global? • Dodd Frank pre-empts some of these issues in the US context

9. Macroprudential • About: • Identifying emerging system wide risks • Understanding the causes of these • Deploying tools (at macro level) to address them • Issues • Structures/avoidance of group-think/capture • What tools? • Interaction with micro prudential and macro economic tools • Critical issues • A crucial issue to get right. But need for very careful thought in design and use of tools • US structures (FSOC) already in place

10. Industry practices • Mistakes and shortcomings in lead-up to the crisis • Essential to get these right • Intrinsically important (regulation not a substitute) • Also necessary to re-establish credibility with supervisors/regulators • IIF has focused on several aspects of risk governance and management • Clear signs of improvement • But are these durable? Getting ‘risk culture’ right is very crucial but also very (very) difficult

11. Current work • Current IIF focus on: • Risk IT: benchmarks, impediments → sound practices • Risk appetite: impediments and sound practice in overcoming these • This is critically important in its own right • Firms have a lot further to go • Also a difficult task in persuading supervisors they are serious and will stick to it

12. Conclusions • Regulatory reform is an absolute priority • Care is needed not to choke-off recovery in the near term • Also a need to ensure that the financial system can support global activity in the long term without being a source of instability • Progress is needed on all fronts: • Regulation • Resolution • Supervision • Macroprudential • Industry practices