In the UK, prudential supervision has returned to the Bank of England and ring-fencing banks will change the country’s financial structure. At the international level, the Basel Accords on banking supervision have been significantly revised, requiring more capital, tighter liquidity and the identification of systemically important financial institutions.
Has this fixed the problem? James Barth, Jerry Caprio and Ross Levine argue that it has not. While accepting that there were many causes of the global financial crisis outside the regulatory framework, they argue that the financial sector is intrinsically vulnerable and that a strong and effective regulatory framework will be required to avoid a repeat of such a crisis. The reforms enacted since 2008 have not addressed the core deficiencies of the regulatory institutions.
These weaknesses are threefold. First, regulators are asked to identify and respond to low-probability ‘tail’ risks, which often develop insidiously over time. Reducing these risks would inevitably trim the profits of financial institutions, putting the regulators at odds with the often hard-driving, self-opinionated finance executives. These executives have substantial personal incentives to push out along the risk–reward trade-off, often relying on official deposit insurance and the ‘too big to fail’ backing.
There is never a right moment to rein in risk taking. Regulators are reluctant to draw public attention by taking action before the bubble has burst, fearing they will be blamed for causing the crisis, not just precipitating its inevitable unfolding. And when action is delayed, regulators are reluctant to toughen their standards for fear of being accused of inconsistency. In an effort to tackle an emerging risk in a single institution, they often make the overall risk worse.
For example, there were clear, early signs of trouble in the US sub-prime mortgage and insurance markets. Despite the Bank of England’s warnings in 2006, the UK regulator praised Northern Rock and allowed an increased dividend distribution just three months before the fatal run on the bank. And in Europe, the Spanish regulators saw the building boom, just as the Irish authorities saw the runaway growth of bank lending. So, why do regulators, after seeing these problems, respond inadequately? The answer is often found in the behavioural characteristics intrinsic to the regulatory process.
Second, regulators are modestly paid, while financial executives are at the top of the salary scale. Not only does this weaken the authority of the regulators, it leaves them open to the subtle inducement of potential future employment in the private financial sector. Sometimes, however, regulatory capture is not financially motivated. It reflects instead the closeness of regular corporate relationships, and this can subsequently result in group-think rather than the independence needed to identify incipient problems.
Third, the political environment favours risk takers in the financial sector. Particularly in the US, the lobbying influence of Wall Street, lubricated by large election contributions, has weighted the legislative system hugely in favour of the financial sector’s interests. The laissez faire free market paradigm is used to dismantle regulation and provide a ‘light touch’ approach to prudential supervision.
The answer, according to Barth, Caprio and Levine, is to create a high-level independent body for regulators. The body should be staffed by experts and well-remunerated officials with diverse skills, who enforce transparency and remain impartial to the daily influences that distort and bias the actions of the micro-level regulators.
Regulators in a number of emerging economies in Asia also face many of the same pressures and constraints. For example, Indonesia, now in the process of splitting prudential supervision from the central bank, has inadequate coordination and interaction between its various regulators. And while the draft Safety Net Law has the potential to create an overriding regulatory body, such an outcome will not occur without a rigorous analysis of the inherent weaknesses of supervisory structures.
As financial sectors develop in these fast-growing Asian economies, rapid innovation and the introduction of new products open up opportunities for risks to exceed the capacity of regulators to constrain systemic threats. But there is also a danger that regulation will be taken too far and the dynamic aspects of finance will be hog-tied in red tape. The Basel Accords are not enough, in themselves. Individual countries must develop their own regulatory structures based on their own specific circumstances.
Stephen Grenville is a Visiting Fellow at the Lowy Institute for International Policy and a former Deputy Governor at the Reserve Bank of Australia.