WRITTEN BY NICK HEASE

The 2007-8 financial crisis created a worldwide tsunami of national debts, deep recessions and financial instabilities on a global scale, with the financial services industry bearing most of the brunt. Commentators often point to the unfettered nature by which finance was able to operate by exposing itself to too much risk through excessive financial leverage, without adequate regulatory oversight. Certainly then, the case for full laissez faire markets now holds little credibility. In the years since the crash, numerous institutions in the US and the EU have looked to implement reforms to remedy systemic deficiencies throughout the financial industry.

Undoubtedly, banks are feeling the aggregate impact of recent regulatory requirements. They now have the challenge of managing their balance sheets in line with new guidelines, by managing cash and financial operations in this new environment. For example, capital ratios introduced by the Basel Committee on Banking Supervision will affect a bank’s decision to take on assets and manage liabilities. For those with experience introducing regulatory changes into a bank’s daily operations, it is evident just how comprehensive these changes have been. In some cases, completely new departments have been set up to ensure compliance with new supervisory pressures, and ensure banks have sufficient capital and liquidity to cover loan losses and cash. However, when looking at the raison d’être behind these reforms, has financial regulation been adequately enforced to prevent further financial instabilities?  In order to attain this goal, regulation has focused predominantly on main objectives: to achieve transparency, while also decreasing systemic risk by ensuring compliance and enforcing minimum standards.

Transparency

The first step towards enforcement is achieving financial accountability through the transparency of information. The financial crisis sparked progress towards improvements in the data received from banks. Under the European Market Infrastructure Regulation (EMIR) and the Dodd-Frank Wall Street Reform and Consumer Protection Act (DF), banks report huge quantities of data to regulators, requiring that all trades be executed under a standardised format and reported to central trade repositories to identify shifts. These repositories are obliged to share information with local and supra-national supervisors. All trades must also be executed through central counterparties to reduce risk and increase transparency. The main principal behind these reforms is the idea that “mandated disclosure” ensures clarity of information to the public[1].

Despite these steps taken to improve accountability, the commitment to transparency has somewhat backfired as the combination of complex and excessive accumulations of information has created an “information glut”[2]. The perpetual efforts to simplify the disclosure of this data prove how difficult it has been to streamline reports into more lucid viewing. Financial transactions are multifaceted and multi-layered by nature, inherently causing regulation to be opaque. Most people are only modestly financially literate, making the disclosure of such overwhelming information an unconvincing route towards legitimising new financial rules. This opacity holds significance given that opaque financial transactions contributed to market participants’ lack of confidence in their ability to value assets. Therefore, on the face of it, disclosure may seem directly beneficial to achieving transparency; yet in reality tangible results often remain elusive without insisting on better quality information.

Systemic risk

Steps have certainly been taken to strengthen and enforce prudential regulation globally, as set out during the 2009 G20 meetings.  For example, a large emphasis has been placed on introducing mandatory regulatory capital requirements at least between 4.5% - 8% of risk weighted assets at all times to ensure banks build a buffer outside periods of turmoil and mitigate cyclical behavior under BASEL III. Modifications to regulatory capital requirements raise the quantity and quality of banks’ capital base, with the introduction of leverage ratio and global liquidity standards. Getting these minimum capital requirements right is important. If overly strict, these could obstruct lending and economic growth; too weak and they allow banks to take on too much risk, which can lead to another financial crisis.

Proponents of stricter financial regulation still argue that current reforms do little to prevent a lax banking system that promotes unnecessary risk-taking, consequently endangering the economy and society as a whole.  They point to the moral hazard argument, whereby equity holders of banks currently have excessive incentives to take on debt knowing in turn governments will bail them out, should anything go awry. Therefore, without enforcing prudential and systemic regulation, banks will tend to have socially harmful incentives, by ignoring or even magnifying their exposure to risk while pursuing maximum returns in the market.

Although steps forward have been taken, the ability of institutions to enforce regulation should remain a priority. BASEL III for example, has no direct power over governments. Instead, Basel Accords are guidelines that are intended to be adopted by each of the member central banks. In fact, none of the existing international institutions (the International Monetary Fund, World Bank, etc.) has an enforceable regulatory mandate for global financial markets. As no new global regulatory institutions with binding authority have been created by the G20, what now exists is an ambitious global agenda with little ability to properly enforce regulation.  This was best illustrated in the UK when the Financial Conduct Authority (FCA) ratcheted up fines in a bid to deter wrongdoing after banks were caught trying to rig the LIBOR rate in 2012. Yet with continued misbehavior and overt risk taking, there is little evidence to suggest such actions work without criminal proceedings taking place. In the case of the LIBOR scandal, only one person was charged. Such events illustrate that despite the formation of new regulations since 2008, banks are still able to mislead and harm consumers and investors, ultimately, putting the global economy at risk.

Conclusions

A number of conclusions can be drawn from the current progresses and shortfalls that exist with present regulatory reforms.  Firstly, accomplishments do stand out: since the G20, eight years of new reforms, ongoing deleveraging and business restraint, as a response to the crisis, has created more robust financial institutions.  As for global financial reform, Basel III and the EU Banking Union, when fully implemented, will certainly decrease global financial risks.  But, can all of this be treated as “sweeping reforms to tackle the root causes of the crisis and transform the system for global financial regulation” as quoted during the G20?

The answer is probably not. The financial system is now fully globally connected, making a coordinated set of enforceable regulations across nation states difficult to achieve. This leaves regulations struggling to catch up with a complex system that is evolving faster than the regulations themselves. The ability of institutions to enforce reforms remains the crucial obstacle towards protecting the real economy from abusive practices and catastrophic collapse. Reforms envisaged to improve transparency, protect against market abuse and decrease systemic risk can only go so far without a global entity that can impose such changes across multiple jurisdictions. Yet the result of failing to meet the basic substantive goals of financial oversight, will result in a financial sector where banks are allowed to pile up ill considered risk upon risk, hold low levels of capital as a buffer against loss, engage in practices that mislead and harm consumers and investors, and ultimately place global economy stability in jeopardy.

References

  • The Dodd-Frank Wall Street Reform and Consumer Protection Act (Pub.L. 111-203, H.R. 4173), full text available athttp://www.dodd-frank-act.us.
  • Bradley, Caroline. “Transparency Is The New Opacity: Constructing Financial Regulation After the Crisis.” American University Business Law Review 1, no. 1 (2011): 7-32.
  • Ben-Shahar, Omri, and Schneider Carl E. “The Futility of Cost-Benefit Analysis in Financial Disclosure Regulation.”The Journal of Legal Studies 43, no. S2 (2014): S253-271

[1] Ben-Shahar, Omri, and Schneider Carl E. “The Futility of Cost-Benefit Analysis in Financial Disclosure Regulation.” The Journal of Legal Studies 43, no. S2 (2014): S253-271

[2] Bradley, Caroline. “Transparency Is The New Opacity: Constructing Financial Regulation After the Crisis.” American University Business Law Review 1, no. 1 (2011): 7-32.