Lucid summary on the future course of financial regulation

The debate about new regulatory regime of the new 'innovative' financial products, many of which turned 'toxic' over th elast year, is relevant primarily to global financial centres. In this regard, the EU10 markets enjoy the 'advantage of backwardness' as bank exposure to complex securities and derivatives seem to be limited. On the other hand, new regulations in the US and UK, will sooner or later proliferate to the list of international financial standards (such as the one maintained by the Financial Stability Forum) and then to EU rules and thus to EU10 legal codes.

The testimony of the Adrew Lo to the US congress, provides rather sober and specific proposals for what may come. It is also one of the few public policy proposals that explicitly builds on behavioral finance and argues for construction of brand new institutions (such as risk focused accounting). He argues that the following seven themes are the key:

1. Crises are to stay, but transparency may limit impact: Financial crises may be an unavoidable aspect of modern capitalism, a consequence of the interactions between hardwired human behavior and the unfettered ability to innovate, compete, and evolve.  But even if crises cannot be avoided, their disruptive effects can be reduced significantly by ensuring that the appropriate parties are bearing the appropriate risks, and this is best achieved through greater transparency, particularly in the so-called “shadow banking system”[i.e. hedge funds].  Government can play a central role in providing such transparency. 
2. Define and measure systemic risk: Before we can hope to manage the risks of financial crises effectively, we must be able to define and measure those risks explicitly.  Therefore, the first order of business for designing new regulations is to develop a formal definition of systemic risk and to construct specific measures that are sufficiently practical and encompassing to be used by policymakers and the public.  Such measures may require hedge funds and other parts of the shadow banking system to provide more transparency on a confidential basis to regulators, e.g., information regarding their assets under management, leverage, liquidity, counterparties, and holdings. 
3. Rutine investigation of collapses and learning: The most pressing regulatory change with respect to the financial system is to provide the public with information regarding those institutions that have “blown up”, i.e., failed in one sense or another.  This could be accomplished by establishing an independent investigatory agency or department patterned after the National Transportation Safety Board, e.g., a “Capital Markets Safety Board”, in which a dedicated and experienced team of forensic accountants, lawyers, and financial engineers sift through the wreckage of every failed financial institution and produces a publicly available report documenting the details of each failure and providing recommendations for avoiding such fates in the future. 
   
4. Good comminication with public durign crisis: To the average American, the current financial crisis is a mystery, and concepts like subprime mortgages, CDO’s, CDS’s, and the “seizing up” of credit markets only creates more confusion and fear.  A critical part of any crisis management protocol is to establish clear and regular lines of communication with the public, and a dedicated inter-agency team of public relations professionals should be formed for this express purpose, possibly within the Capital Markets Safety Board. 
   
5. Construct risk accounting: Current GAAP accounting methods are backward-looking by definition and not ideally suited for providing risk transparency, yet accounting measures are the primary inputs to corporate decisions and regulatory requirements.  A new branch of accounting—“risk accounting”—must be developed and widely implemented before we can truly measure and manage systemic risk on a global scale. 
   
6. Create capacity to handle financial complexity by paying PhDs: All technology-focused industries run the risk of technological innovations temporarily exceeding our ability to use those technologies wisely.  In the same way that government grants currently support the majority of Ph.D. programs in science and engineering, new funding should be allocated to major universities to greatly expand degree programs in financial technology. 
   
7. Ratcheting standardization: The complexity of financial markets is straining the capacity of regulators to keep up with its innovations, many of which were not contemplated when the existing regulatory bodies were first formed.  New regulations should be adaptive and focused on financial functions rather than institutions, making them more flexible and dynamic.  An example of an adaptive regulation is a requirement to standardize an OTC contract and create an organized exchange for it whenever its size—as measured by open interest, trading volume, or notional exposure—exceeds a certain threshold. 
   

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Financial crisis foretold

As the financial crisis spread through the world, so does the disbelief that no one was able to predict what is to come. The banks, banking regulators, governments and international organizations, have armies of analysts and consultants, but they all seem to be surprised. This is however only partially the case.

It is true that no one at the top table of global finance - the FED, the G8, the IMF - stood up and told the world that the period of easy money is unsustainable and unless we take action to constrain it, we would hit the wall. However, many of the analysts buried deep in the hierarchies of these organizations indicated the problem. This is a quote from the 2005 speech of the IMF's Deputy Managing Director about financial sectors in EU15:

A first issue is the increasing exposure of domestic banking systems to economic cycles and developments in other countries¸ as banks extend their operations outside their home bases. In some cases, stress tests conducted during the FSAPs found that depreciation of the dollar combined with a global slowdown could be a source of significant risk to the loan portfolios; in other cases, growing exposure to transition economies in central and eastern European countries, while important for boosting profitability, was identified as a potential source of risk.

A second risk factor is the sizeable exposure of banking systems to what appear to be substantially over-valued property markets in several countries. This point has been flagged by the IMF in its regular analyses of global economic developments in recent years.

And about EU10:

... various FSAPs pointed to a number of risks, including those stemming from rapid credit growth in new and potentially riskier sectors. In nearly all the CEE countries, credit risk in loan portfolios, including that arising from exchange rate fluctuations, remains the main systemic vulnerability, although sensitivity analysis suggests, in many cases, considerable banking system resilience to a deterioration in credit quality. Another risk factor is that growing banking competition in CEE countries, and the ensuing pressure on profit margins, may encourage some banks to venture into more risky lending in order to protect returns.

In retrospect it clearly may be more the problem of bosses of these analysts who failed to pick up the key line in the cacophony of economic debates and repeat it bluntly at the top table. Especially, to Americans and Chinese ....

... who did not really want to hear this message derived from the Financial Sector Assessment Program of the IMF and World Bank that has been finished over the last 9 years for 140 countries (out of 185 members of WB/IMF). The program is non-binding and voluntary so only countries who apply are assessed. There are two important members who never applied - USA and China.

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So states have no power vis-a-vis efficient financial markets?

James Surowiecki of the Wisdom of the crowds fame, pointed out in his New Yorker blog:

When news broke that Timothy Geithner was Barack Obama’s pick for Secretary of the Treasury, the stock market jumped more than six per cent in the space of an hour. Obviously, this was a good thing, but there was also something weird about the spectacle of the Street’s once fearless free marketeers exulting over a government appointment, as if they were nomenklatura members cheering a new Politburo chief. It showed just how central a few government officials have become to the well-being not just of the markets but of the economy as a whole. For better or worse, we now live in a world in which the Treasury Secretary controls hundreds of billions of dollars in spending and shapes the fate of some of the nation’s biggest companies. That’s quite a job to ask someone to do.

Indeed, the "masters of the universe" start to cling to the nanny state as overconfident adolescents to their mother after they smashed their noses on reality. Despite all the proclamations that states do not have powers to regulate global financial markets, this is a refreshing return to normality. Financial markets as as embedded in the political communities (states) as most adolescents in their families.

Robert Skidelsky, while examining the intellectual foundations of the finance adolescent (here and here), takes the disembedding idea a notch further. It is not the problem of political dissembedding, but moral one. He claims that

The key theoretical point in the transition to a debt-fueled economy was the redefinition of uncertainty as risk. This was the main achievement of mathematical economics. Whereas guarding against uncertainty had traditionally been a moral issue, hedging against risk is a purely technical question.

Well it is easy to play schadenfreude on the Wall Street bankers, but the more I read about the financial crisis, the deeper it seems to go. It is not just regulatory failure compounded by the macro profligacy, which would be the issues of wrong state policies and institutions. The underlying intellectual models - such as efficient market hypothesis and a bundle of formalized mathematical models that build on it - seem to get it very wrong. May be I just read the wrong books like Black Swan and Engine, not a camera.

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Hungarian promises to IMF

Hungary had signed a Stand-by agreement with IMF on November 4, 2008. Apart the standard clauses on the fiscal and monetary policy, it includes a section on the financial sector policies. Although, these commitments are made under pressure to fence off the impact of the global financial crisis, they may foreshadow future changes of the EU10 banking regulatory regimes.

The reason why Hungary is threatened by the financial crisis more than her Visegrad neighbors is fiscal profligacy of her government. High debts and high deficits of public finance over the last few years induced the independent central banks to restrictive monetary policy. In turn, high interest rates (and rather stable exchange rate of forint) motivated households to borrow in euro, Swiss francs or even yen. This resulted in the much higher vulnerability of household balance sheets as they essentially bear unhedged exchange rate risk. Both of these risks were exacerbated by the financial crisis that triggered liquidity trap and capital outflows from emerging markets.

In this context, the Stand-by agreement reviews what by today counts as standard firefighting measures including:

• IMF stand-by of up to 12.5 bn euro for the next 17 months;
• ECB lending facility of up to 5 bn euro;
• EBRD is also mentioned as ready to step into banks;
• doubled deposit insurance from 6 to 13 million HUF, topped by blanket guarantee of all deposits;
• providing a support package for systemically important banks that contains provisions for added capital and funds a guarantee fund for interbank lending (up to HUF 600 billion in total); this support could increase banks' CAR to 14 pc.

To address the foreign lending problem of households, the agreement envisages that banks and indebted families would

• at the request of the debtor, allow the duration of the loan to be extended with fixed monthly installments;
• debtors who deem that exchange rate fluctuations carry excessive risks will be allowed to convert their foreign currency-based loan to a forint loan, without extra charges; and
• in the event that a debtor is unable to service the existing loan, the banks will be amenable to transitionally reducing the installments at the request of the debtor.

The crisis also induced the Hungarian government to submit laws to the parliament that would allow Hungarian Financial Service Authority and financial infrastructure to catch up with most of their EU10 neighbors have done few years ago.

• Introducing numerically defined triggers of remedial actions and emergency powers;
• improving the efficiency of the bank resolution regime to facilitate paying out quickly to depositors in case of need.
• introduction of a positive credit registry for households,
• modification of the Central Bank Act to allow the MNB to request individual but unidentifiable data to adequately analyze credit risk,
• enhanced regulation of insurance and credit brokers and their products,
• introduction of maximum loan-to-value ratio requirements for new mortgage loans, and
• close monitoring of banks’ foreign exchange exposures
• strengthening communication with financial authorities in home and host countries regarding risk assessments and liquidity contingency plans. 

Judging what all this means for the future of banking regulation in EU10 is fraught with uncertainties. However, unless we see major moves on the EU level and providing that existing regulatory regime will only be patched not scrapped, we could observe the following:

• a comfortable capital adequacy for turbulent times in emerging markets is neither 8 pc required by Basel I, nor 9 to 12 pc. observed across EU10, but more (Hungarian government on betting on 14);
• reintroduction of some simple regulatory measures such as loan-to-value ratios that fell out of fashion during the good times;
• to make the EU10 regulatory regime credible vis-a-vis parent banks and their home-country regulators, a rigid triggers of regulatory action may be needed;
• more transparency and data sharing to monitor system level risks;
• integration of regulation of banking and other financial services;
• stronger regulatory cooperation on EU level.

All of this has always been on the table. However, the unpleasant experience of Hungary and also Baltic states and Romania and Bulgaria, may help to turn the proposals into action.

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G20 on banking regulation and leadership responsibility of EU

The G20 meeting this weekend was more important for the fact that major emerging economies were invited than for the substantive decisions. It all makes sense to get India and China at the same table with G8, but it does not make it easier for the US to swallow any kind of supranational financial regulation. I guess we need to wait for the new brand of Obama multilateralism to see any progress on this front.

The G20 statement is thick on good intentions, but thin on specific proposals:

Increased transparency of financial sector, regulation of rating agencies, avoiding pro-cyclical regulation, increased information sharing between national authorities, expanding the FSF to include emerging economies and ensuring that IMF and other multilateral institutions to have sufficient resources to support emerging economies capital needs.

It practically shift the ball to the Financial Stability Forum that should develop substantive proposals for the next meeting of G20 in April 2009.

I doubt that FSF would be able to cut through the complexity of the global financial markets and formulate the future vision of the global financial architecture that could deal with all aspects listed by G20. Actually, I believe the EU 27 should be the leader in terms of substance of the new financial regulations. If EU cannot make progress towards supranational regulatory regime, than chances for global progress are slim.
Today EU is composed of both developed (EU15 + 2) and emerging economies (EU10) and its financial sectors cover the full spectrum from cutting edge of finance in the City of London, to rather sleepy backwaters in Prague or Bratislava (today the 'advantage of backwardness' is worth billions of dollars as it means little exposure to 'innovative' financial products that proved 'toxic' so Czech and Slovaks may still hope to get through the financial crisis without involvement of state finance). At the same time, EU financial markets are highly integrated, but the regulation is still based on home-coutry supervisors and its supranational dimension did not progress beyond vague memoranda of understanding and moreorless informal consultation process.
EU is well aware of the discrepancy between the financial integration and fragemnted regulation. Few years ago it even devised so called Lamfalussy procedure to be able to catch up on the regulatory side. However, even before the financial crises the regulatory integration hit the wall. Even the idea of regulatory colleges for major internationally active banks that now seems a nobrainer proved too politically contested to be passed.
As is often the case, lack of compromise boils down to interest-group politics. The policitical cleavages among vested interests in different countries proved too numerous. Brits, like Americans on the global scale, are suspicious on the supranational regulators. French push for centralized heavy-handed approach. Germans worry about their para-statal landes banks. The EU10 countries are not quite sure whether they should try somehow to adjust their regulatory regimes to the fact that all their banks are controlled from abroad (so they just hope for the best now). Moreover, the non-euro countries are not keen on letting ECB (which usurped the bank supervision responsibilities) to supervise their banks. Moreover, the retail banks are not keen on reducing regulatory barries to competition, whereas wholesale banks support it. Moreover, parties on each side of these plentiful cleavages are shiftting all the time. No wonder EU did not make much progress.
On the other hand, time of crisis force some clarity of thinking and make clearer the relative costs and benefits of various arrangements. Some refined objections to supranational regime lose their persuasiveness as bad news keep coming. Some political compromises, such as argeements on burden-sharing of fiscal cost of banks active in many EU countries, that would be unthinkable in the normal times may be possible in extraordinary times. Economists call this benefit of crisis. If EU could seize on them, the rest of the globe would be more likely to follow.

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Marek Belka and Erik Berglof: New Europe Catches Old Europe’s Cold

via Project Syndicate on 11/11/08

LONDON – As governments across Western Europe began bailing out banks and their depositors, Eastern Europeans watched nervously, unsure about what the global financial storm would mean for them. Now that the storm has hit, the fragile bonds of European solidarity are being tested.Two countries – Hungary and Ukraine – have already asked for large packages of support. Several more could do so over the next month if frozen credit markets do not thaw. If the situation continues until the end of the year, which cannot be ruled out, many more countries could experience serious banking crises.Over the last two decades, Eastern Europe has undertaken wide-ranging reforms and embraced global financial integration. Foreign, mostly European, banks have entered these markets with unprecedented speed and force. These banks have increasingly reached out to more risky small- and medium-sized enterprises and helped people buy their own houses and start new businesses. But successful financial development is now coming back to haunt these countries.Until now, the countries of emerging Europe withstood the global financial squeeze remarkably well, coping with the slowdown in important export markets and increased borrowing costs. But no open economy can resist a complete shutdown of the lending markets. Perhaps they became too dependent on cheap credit, but they were not alone in this respect.Some foreign banks are now withdrawing liquid funds from subsidiaries in emerging Europe. According to the National Bank of Russia, foreign banks withdrew more than $10 billion in that country in September alone. Other central banks make similar claims. To be fair, Raiffeisen International has announced that it was supporting its Ukrainian subsidiary, Bank Aval, with an additional €180 million. Whether other parent banks active in the region stand by their subsidiaries depends on how severe the crisis in Western Europe becomes.But the Western European bailout packages could make the situation in emerging Europe worse. While most parent banks in the region are likely to benefit from these measures, this does not necessarily translate into support for their foreign subsidiaries. In fact, there is a serious risk that these bailouts will come at the expense of Eastern Europe. Several governments have declared that taxpayer money cannot go into operations abroad.Governments in emerging Europe should, of course, play their part in stabilizing their financial systems. But at this point there are severe limits to what they can do. Most do not have the financial clout to counter the extraordinary pressures from financial markets. An offer by Hungary’s government to extend a general guarantee of deposits or to ensure liquidity in interbank markets has limited credibility.To survive this crisis, emerging Europe needs support from outside. First and foremost, West European leaders must ensure that the crisis is resolved at the core, and many observers doubt that they have done enough. Second, they must prevent the crisis measures already taken from discriminating against subsidiaries in Central and Eastern Europe, independently of whether they are within or outside the European Union. Third, they must combine forces, as in Hungary, with international financial institutions in supporting these economies.Georgia’s experiences following its recent war with Russia offer a possible model. The International Monetary Fund provided an emergency credit line to support the currency, the World Bank coordinated the relief effort (much of it financed by the United States and the EU), and the European Bank for Reconstruction and Development used its knowledge and resources to lead the effort to save the financial system. The Georgia package is not a done deal, and circumstances elsewhere are different, but it shows that standard instruments can go a long way.Yet more resources and new instruments will be needed. The case of Hungary shows that the EU can tweak an existing instrument – balance-of-payment support – and use it creatively. For non-EU countries, like Turkey and Ukraine, innovative ideas are also urgently needed.There should be no doubt about what is at stake. It is has been little noticed, but in the last few years, Eastern Europe, including Russia, surpassed the US and the United Kingdom as the euro zone’s most important export markets. Many of these markets now face slowdown or even negative growth. Moreover, Western European companies have invested on a previously unimaginable scale. There is a serious risk that, if the crisis becomes even worse, East European governments will see no alternative but to nationalize some institutions, particularly some of the foreign-controlled banks.But, even more importantly, decades of financial development and broad economic reforms could unravel. As in Western Europe and the US, governments will again play a larger role in the economy, but state involvement has different connotations in these former socialist economies, particularly as they now face a backlash against financial development and against reformers.As if this was not enough, Western governments and businesses should ponder what kind of offers may come from Russian sources, private or public, for distressed banks and companies. No doubt with strings attached.

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Rating downgrades of CEE countries

S&P and Fitch responded to mounting risks from global credit crunch by
downgrading or revising credit rating outlook to negative for Baltic
states, the Balkans, and Hungary in October and November 2008. [from
RGE monitor]

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Back to the 1990s: bank nationalization in Latvia

The queues of depositors and overnight government sessions discussing state takeovers of private banks are back. In Latvia the answer was yes, when the state took over the second-largest bank - Parex Banka - on November 10, 2008. This bought back memories of collapse of Banka Baltija in 1995, which was one of the few cases of large bank collapses in EU10 that were not fully compensated to small depositors.

The choices faced by the Latvians were the usual dilemma with the too-big-to-fail banks:

"This was the choice: to allow the bank to go bankrupt or to secure the financial system," Slakteris [Latvian minister of finance] said, further explaining the decision.

The government estimated that compensating the Parex depositors would cost about 1 billion euro and reckoned that taking the bank over, stabilizing it and reselling in less turbulent times, may be a better option. The government bought out the largest shareholders of Parex and got the 51 percent stake for just under 3 euros.

In the context of EU10 banking markets, Parex was an unusual case. It was controlled by local interests, with its chairman being the largest shareholder. Most of banks with such an ownership structure in other EU10 countries went under much earlier or in a few happier cases were taken over. Today major banks in most EU10 countries are part of some multinational financial groups.

There are some other exceptions such as Hungarian OTP, which is also controlled by its chairman and dispersed shareholders. The OTP recently faced a speculative trading on the Budapest stock exchange, which may suggest that banks that are not controlled by a dominant foreign owner may have one more reason to worry throughout the current uncertainty on the markets.

What this story tells us:

• So far the reliance on the foreign bank ownership pays off for EU10 countries. Being part of the transnational banking group is clearly an advantage for EU10 banks. It provides some guarantee that parent banks would step in in case of losses (for example, Swedish banks that dominate banking sectors in the Baltic 3, can write-off 10% of all their assets in these countries, without their prudential indicators reaching minimal levels).
• There is an 'advantage of backwardness' for EU10 banks and banking sectors. They did not get too involved with toxic assets from US, because this kind of proprietary trading is done on the financial group level in one of the European financial centers. Given that EU10 banks are locally incorporated (i.e. not mere branches under the EU single-passport rules), they are protected from toxic stuff by the limited liability of their parent.
• It also tells about the phenomenal growth of the Baltic economies over the last few years. Over the last three years, Latvian economy grew by over 10 percent annually. At the same time, the credit to domestic private sector grew from 50.8 to 93.7 pc of the (fast growing) GDP. This indicates high credit intensity of growth and most likely a pile of non-performing assets as the economy gets to recession.

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What may come from the G20 meeting on financial reform

In a week the G20 meets in Washington to agree on the reform of global finance. It seems that no revolutionary idea is in the pipeline:

... leaders said they want an early warning system to watch for imbalances in financial markets, make the International Monetary Fund the world's financial watchdog, improve supervision of financial players and close loopholes that let some institutions avoid regulation. (see here)

The biggest news is that US is ready to go along with EU and introduce new regulations. However, they should start at home and clear the mess of the 150+ bodies that regulate different segments of US financial markets on federal and state level. If EU and other international partners could negotiate with just one insurance regulator rather than 50, reaching some conclusion might be easier. I suppose the days when [US] economists pride themselves that "regulatory competition" among 50 state jurisdiction is great for 'innovation' on financial markets are over.

The BRIC seem to be pushing for greater representation in IMF and World Bank, which is justified, but this issue should not crowd out the real work on global financial architecture.

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Government pressure on banks in China

I have just sent the final version of my paper on Banking reforms in China (see pre-rint version here).

The last senstense of the abstract reads:Selectiveness of institutional reform means that the largest banks remain under state control and can be used as means of development policy for the better or the worse.

It seems that this claim will be tested soon. Today Bloomberg reports:

China's largest banks, with 4 trillion yuan ($586 billion) of cash, are resisting government efforts to boost lending to 42 million small and medium-size companies that drove the economic boom of the past decade. On Nov. 2, the central bank scrapped curbs on loans after three interest rate cuts in seven weeks failed to revive economic growth that has sagged to its slowest in five years.

It will be interesting to see whether the Chinese goverment will puch its will through the indirect regulatory tools and agreements that respect proclaimed commercial autonomy of banks or whether will resort to traditional force of pushing its will via party committees and personel policies that they control.

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