Thursday, July 31, 2014
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Financial Regulators’ Global Variety Show

PARIS – In the early phases of the financial crisis, it was fashionable to argue that the United States’ system of regulation needed a fundamental structural overhaul. Differences of opinion between the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) had obstructed effective oversight of investment banks and derivatives trading (only the US believes that it makes sense to regulate securities and derivatives separately).

Indeed, the plethora of separate banking regulators had created opportunities for banks to arbitrage the system in search of a more indulgent approach to capital. Likewise, the lack of a federal insurance regulator had left AIG regulated by the Office of Thrift Supervision (OTS) and the New York State Insurance Department, which proved to be a wholly inadequate arrangement.

Little has come of these arguments. The Dodd-Frank Act did succeed in putting the OTS out of its misery, but jealous congressional oversight committees have prevented a merger of the SEC and CFTC, and nothing has been done to rationalize banking supervision. So the American system looks remarkably similar to the one that turned a collective blind eye to the rise of fatal tensions in the early 2000’s.

One factor that contributed to institutional stasis was the absence of a persuasive alternative. In the decade or so leading up to the meltdown of 2007-2008, the global trend was toward regulatory integration. Almost 40 countries had introduced single regulators, merging all types of oversight into a single all-powerful entity. The movement began in Scandinavia in the early 1990’s, but the most dramatic change came in 1997, when the United Kingdom introduced its Financial Services Authority (I was its first chairman).

Other countries adopted slightly different models. A fashionable approach was known as “twin peaks,” whereby one regulator handled prudential regulation – setting capital requirements – while another oversaw adherence to business rules. But twin peaks itself was further subdivided.

The Dutch model brigaded the prudential regulators inside the central bank, while the Australian version was built on a separate institution. These integrated structures seemed to offer many advantages. There were economies of scale and scope, and financial firms typically like the idea of a one-stop (or, at worst, a two-stop) shop. A single regulator might also be expected to develop a more coherent view of trends in the financial sector as a whole.

Unfortunately, these benefits did not materialize, or at least not everywhere. It is hard to argue that the British system performed any more effectively than the American, so the single-regulator movement has suffered reputational damage. And the continuing travails of the Dutch banking system – another bank was nationalized last month – suggest that it is easy to fall into the gap between twin peaks.

The truth is that it is hard to identify any correlation between regulatory structure and success in heading off or responding to the financial crisis. Among the single-regulator countries, Singapore and the Scandinavians were successful in dodging most of the fatal bullets, while the UK evidently was not. Among the twin peak exponents, the Dutch system performed very poorly indeed, while Australian financial regulation may be considered a success.

Does it matter whether the central bank is directly involved? Many central bankers maintain that the central bank is uniquely placed to deal with systemic risks, and that it is essential to carry out monetary and financial policies in the same institution. Again, it is hard to find strong empirical support for that argument.

The Dutch and American central banks, with direct oversight of their banking systems, were no more effective in identifying potentially dangerous systemic issues than were non-central bank regulators elsewhere. Canada is often cited as a country that steered its banks away from trouble, even though they sit uncomfortably close to US markets. But the Bank of Canada is not now, and has never been, a hands-on institutional supervisor. So perhaps the US Congress has been right to conclude that changing the structure of regulatory bodies is less important than getting the content of regulation right.

Elsewhere, though, a lot of structural change is under way. In the UK, every financial disturbance leads to calls to revamp the system. There were major overhauls in 1986, and again in 1997, when the Bank of England lost its banking supervision responsibilities as a delayed response to the collapse of Barings. Next month, it gets them back – and more.

For the first time, the Bank of England will supervise insurance companies as well. A similar change has been introduced in France, where a new Prudential Control Authority has been created. The British and French rarely agree on anything; one is tempted to say that when they do, they are highly likely to be wrong.

It is difficult now to discern a coherent pattern. Certainly, the trend toward full-service single regulators outside the central bank has slowed to a crawl (though Indonesia is consolidating regulators at present). There is no consensus on the role of the central bank: in around a third of countries, it is the dominant player, in another third it has responsibilities for banks only, while in the remaining third it is a system overseer only.

We could see this as a controlled experiment to try to identify a preferred model. After all, financial systems are not so different from one another, particularly in OECD countries. But there is no sign of a considered assessment being prepared, which might at least help countries to make better-informed choices, even if it did not conclude that one model was unambiguously best. The G-20, under its current Russian presidency, is now in search of a role. Here is a useful practical task it might take on.

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  1. CommentedJames Daniel Paul

    Stage 1: Industrial revolution thro wars
    Stage 2: Multilateral Organisations
    Stage 3: Economic Reforms for market Economy and privatisation
    Stage 4 FTAs
    Stage 5 Regional Lenders
    Stage 6 Company regulators
    Stage 7: Banking regulator
    Stage 8 Stock market Regulator
    Stage 9 Insurance and social security regulator
    Stage 10 Interventions in the debt market
    Stage 11 Interventions in the forex marekts
    Stage 12 Commodity market Regulators

    from Government to Market to Regulation !! interesting evolution of the market in India

  2. CommentedJonathan Lam

    Gamesmith94134: Financial Regulators’ Global Variety Show

    I would appreciate Mr. Howard Davies giving insights on the financial; and it reminded me the early days when I learned economics. It brought back memories.

    There is no difference on the OTS or FSA, they are Names and they repeated the history of the Lloyds of London; and how do you compare ICE and CFTC to Mr. Murray Lawrence? It is all displays by the same taxidermists as those regulators agreed on the rules to securities and derivatives on the separated grounds; albeit, compartmentalization or internalized as you will. It is upgraded to “recruit to dilute”.

    “at first instance the judge described the Names as "the innocent victims [...] of staggering incompetence" and at appeal the Court found that representations that Lloyd's had a rigorous auditing system were false ([item 376 of the judgment:] [...] the answer to the question [...] whether there was in existence a rigorous system of auditing which involved the making of a reasonable estimate of outstanding liabilities, including unknown and unnoted losses, is no. Moreover, the answer would be no even if the word 'rigorous' were removed.)”

    I would not doubt if many more financials would fall through the gaps of the “twin Peak”; they will collapse like Barings. It is because compartmentalization or internalization are molding the individual system to comply and ligation break the rules of its only since only one to make its rule. However, I would prefer the gentlemen’s agreement than under the law, it is the common sense that bonds underwriters, regulators and investors together, and they compromise. Perhaps, I am kind of nostalgic that we can return to the old days that the Names must be changed…….and the attitude on profits and responsibilities should be shared among the Names; If only God will, not even the G20.

    It is time for the emerging market nations and developed nations to commit themselves not to “recruit to dilute” or give a definition of the unlimited and limited liabilities; because we all learned by now that debtor and creditors are interchanged positions financially----we are all liable to other.

    “Twin Peaks” is just another hump on the same camel.

    May the Buddha bless you?

  3. CommentedProcyon Mukherjee

    Howard Davies writes an excellent summary on the nuances of regulatory overhaul in the finance sector that many countries have gone through in recent times; in all its uniqueness that each country had attempted to reconfigure the regulatory role, we have actually more of the same as the result. The steep increase of financialization did not leave as a rich dividend the increase in output per worker as a share of employment in finance as the BIS paper 69 has shown that “if output per worker is plotted against the share of employment in finance, there emerges a point where both financial development and financial system’s size turn from good to bad beyond a point (that point lies at 3.2% for the fraction of employment and 6.5% for the fraction of value added in finance). Based on 2008 data, the United States, Canada, the United Kingdom and Ireland were all beyond the threshold for employment (4.1%, 5.7%, 3.5% and 4.5%, respectively). And the United States and Ireland were also beyond the threshold for value added (7.7% and 10.4%, respectively)”.

    This apparent dysfunctional arrangement had raised the doubt that financial markets instead of propounding systemic stability, consumer protection and risk mitigation practices to benefit large sections of people may have actually not served the lofty goals of bringing financial service access to greater majority of people, who go through the pains of adjustment more than the larger institutions; in providing the balance between serving
    those sections who have less knowledge of the products on offer that could advance credit and could be actually used judiciously through a mode of smoothening consumption (not excessive leverage), the larger focus had shifted to misallocation of resources to housing and consumer credit at an alarming rate which is not sustainable.

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