Pratip Kar: Issues in Regulatory Reform

Last Updated: Sun, Feb 07, 2010 20:10 hrs

For several years, so many people have been paying so much for doing so many things which were then considered acts of ingenuity and intelligence, but they turned out to be acts of stupidity and disgrace in hindsight. When this happens on a large scale, affecting often the largest and the proudest financial institutions, governments and central banks settle for aggressive action — unprecedented in both magnitude and scope — to revive and maintain market functions. The concern is that their outright failure would irreparably impair market functioning and push the real economy down the slippery slope of recession. The redux and reprise fall on the overarching regulatory architecture in an effort to strengthen and reinforce the embankments and ring fences to prevent recurrences. This is what is happening now, especially in the US and, reluctantly, in Europe. One of the foremost voices of this reform process in the US is that of Paul Volcker, a former chairman of the Federal Reserve, and now the chairman of the president’s Economic Recovery Advisory Board. But the point of discussion in this article is not the success of "Volcker’s rule", which is now being debated in the US Congress, or the proposed Wall Street shake-up by President Barack Obama. It, in fact, is to raise the question of the need to introspect if everything is right with our own overarching architecture of financial regulations, for we too have our share of large financial institutions which we could be proud of.

We may discover that we have been able to divine the most perfect regulatory system and that our financial institutions are the most vigilant and have the ideal risk-management system; and that all our asset markets are well regulated; or maybe, that there are some with feet of clay. But, the truth can be discovered only through an unbiased examination of and a debate on the present regulatory architecture; and it is better that we begin this examination on our own now, because sooner or later, global capital flows will exert pressure on our system to do so.

Three issues become central to this introspection. One arises out of the multiplicity of regulatory institutions governing the financial markets; the other relates to the extent to which a regulatory framework is able to wrestle with the risks in the system; and the third deals with the role of supervision.

The debate over multiple vs single regulator is quite old. Votaries of both sides have many arrows in their quivers. Both the models of financial regulation have been tried in countries that have been affected by the present financial crisis, and it is difficult to make a pronouncement on one model over the other. In the US, for example, a point is now being made for a new regulator for insurance and also for a new "resolution authority", a specifically designated agency which would be authorised to intervene in the event of a systemically critical capital market institution standing on the brink of failure. In the UK, all regulations are rolled into the Financial Services Authority.

The point of issue is not about one versus many regulators, but essentially like the 4 Cs of diamond, it is one of coordination, conflict, consistency and cost, whether within multiple departments of one monolithic regulator or amongst multiple regulators. This is more serious than the current levels of coordination in our market.

In mature financial markets, it would be practically unavoidable for a financial institution to offer products that will stride across different financial regulations, or for a financial product to have multiple features and benefits, each with different risks but falling under the purview of different regulations which may be in conflict with each other. Restricting such products could be the easiest way to deal with such situations, but it will be detrimental to the growth of the market. The other more difficult way is to coordinate among different regulations in a cost-effective way. This is easier said than done and it would require imagination as well as balancing of the 4 Cs. Difficulty would also arise from the familiar turf battles waged tacitly among regulators to protect their own constituencies and to establish individual suzerainty.

Wrestling with risks
The critical issue with regulatory architecture is its ability to deal with regulatory risks and understand to what extent it can wrestle with these risks. It is important that the system is able to anticipate these risks, recognise them as they arise, analyse the relationship among the connected entities and understand how risks can flow from one connected entity to the other, even when institutions that run these risks make every attempt to ignore these risks as they are institutions that consider themselves as "too big to fail". These risks may be present not only in our domestic financial institutions, but also among the foreign institutions. They have the potential to spread the contagion.

Just as execution is the essence of all business strategies and good businesses have often failed because of faulty execution, regulations can fail without balancing improved capital requirements and leverage restrictions with effective regulatory supervision. Derivatives are one form of such instruments which allow possibilities of leverage and, in association with proprietary trading, can allow the leverage to balloon out of proportion. We need to be cautious of the potential of leverage.

All the three issues, multiplicity of regulators vs single, wrestling with the risks in the system and the role of supervision are interrelated. The Joint Forum of the Basel Committee on Banking Supervision, the International Organisation of Securities Commissions and International Association of Insurance Supervisors issued a Joint Forum "Review of the Differentiated Nature and Scope of Financial Regulation" on January 8 to deal with these issues. The report recommends consistency in regulation and similar supervision for similar activities as the key principles for effective oversight of systemic risks. The objectives of the review were to identify potential areas where systemic risks may not be fully captured in the current regulatory framework and to make recommendations on needed improvements in order to strengthen regulation of the financial system. Regulatory architecture and ‘animal spirits’
In the final analysis, when and if we decide on introspection of our regulatory architecture, we should, as Akerlof and Shiller say in their latest book Animal Spirits, keep in mind that in the financial world, "economic events are (not) driven by inscrutable technical factors or erratic government action", and that "the public, the government, and most economists (are) reassured by an economic theory that said that we were safe. (But) it had ignored the importance of ideas in the conduct of the economy. It had ignored the role of animal spirits. And it had also ignored the fact that people could be unaware of having boarded a rollercoaster". We would necessarily have to pay heed to this idea of animal spirits in our retrospection of our regulatory policies.

The author is a former executive director of Sebi and is currently associated with the Global Corporate Governance Forum of the International Finance Corporation and the World Bank.

Views expressed are personal.  

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