Financial regulation remains as complex as ever. Complex new niches such as shadow banking, Fintech, and Over-the-Counter Derivatives, and the increasing interconnectedness of Financial Institutions (FIs) across the world, have led to greater risks to be managed for regulators.
With this in mind, how they manage to get ahead of these rapid financial evolutions and create a proactive framework as opposed to individual policy reactions is not an easy question to answer.
The FSB’s most recent report – Implementation and effects of the G20 financial regulatory reforms – covers the long and short of the progress the G20 has made since the 2009 Global Financial Crisis in creating a better financial sector for all. It is a good preliminary outline of where we are now: a much needed lookback on whether the regulations of the last six years have managed to reflect the seemingly proactive and structured 92-point plan drawn up in Pittsburgh as a response to the Global Financial Crisis (GFC). Their take is split into four areas of differing improvement:
Building resilient financial institutions
One almost universal observation of the recent financial reforms is that banks have significantly built up their capital buffers. Under Basel III, most jurisdictions have in fact been able to implement these additional capital requirements without a lot of stress. Despite some complaints from banks and other spectators, the FSB assert that the capital has been raised mainly from retained earnings and issuing equity, at little expense to bank lending. The increase in risk-weighted assets has also increased the appetite for more secured lending – however this is also under criticism for its apparent effects on small businesses.
Slightly further down the line of progress are efforts to end TBTF. While most Global systemically important FIs have been identified (and are subject to increased scrutiny and requirements), recovery and resolution plans (RRPs) are significantly lagging behind the standards set by the FSB. Given that the second is the crucial step in the process, work is needed pretty urgently here.
Making derivatives markets safer
There is a further lack of progress with derivatives reform, which is uneven at best. The main issue here is that, despite central clearing being mostly welcomed as a risk reducing concept, the frameworks for central clearing are being implemented on completely different timescales and of differing complexity across jurisdictions. Central clearing has come to be one of the most prominent challenges for FIs working on a cross-border basis, and this needs to be addressed.
Transforming shadow banking into resilient market-based finance
While progress is indeed being made here, there is a lack of significant movement on the policy front. This is likely a result of the incredible amount of time and resources needed into actually identifying, understanding and monitoring the shadow banking sector before regulations can even be drawn up. Yet with the final text of the EU Securities Financing Transactions Regulation (SFTR) now adopted – containing both reporting and collateral reuse obligations – we could soon begin to expect the change we’ve been waiting for.
The main implementation challenges in OTC derivatives reform and RRPs are attributed by the FSB to the need for further cross-border cooperation. It is indeed true that with the increasing global nature of the financial system, cross-border cooperation is not just a fly in the ointment but essentially one of the main underlying issues that needs to be addressed. Solutions include strengthening IOSCO’s regulatory toolkit and other globally structured regulations – which we will be mentioning shortly.
So what does the market think of these vast and far-reaching changes?
The climate today compared to how it was say, six years ago, is totally different. The regulatory pendulum is by all means at the very top of its post-crisis swing. Bank CFOs now rate compliance as their top concern and impediment to growth according to a recent survey, and Emerging Market and Developing Economies (EMDEs) are having a hard time keeping up with the size of regulation compared to their domestic markets.
Most would assume that with a huge focus on investor protection, it would be as simple as investors loving regulation and financial intermediaries hating it. Yet a newly published report by Northern Trust revealed how investors and fund managers actually feel similarly towards the regulations – believing that at least some have been useful in reducing systemic risk, namely Basel III and recovery and resolution efforts. So in general, it’s a mixed climate.
But we are at somewhat of a quandary – both the FSB report, the Northern Trust Survey, and a wide range of banks, journalists and economists agree that there is less risk under the increased capital requirements and the deleveraging of global FIs; but the issues highlighted above with regards to lack of cross-border cooperation across jurisdictions still threaten financial stability. The interconnected and global nature of the modern financial infrastructure has rallied concerns around poorly regulated jurisdictions, low commodity prices, and US monetary policy, as highlighted in the most recent meeting of the CIS RCG.
Despite a general increase in liquidity providers, the FSB indeed mention that recent bouts of market turmoil have shown the risk of sudden and sharp price movements and the inability of liquidity providers to offset this. China’s Black Monday this August also made sure of highlighting this dilemma.
Fortunately, there have been some very promising attempts to increase structural robustness and transparency through initiatives such as the LEI and CRS. Issues with data quality appear throughout the FSB report, always going back to a lack of a fundamental framework for all regulations across all borders. The Global LEI System, proposed in 2011 as a unique identifier code to be assigned to all market participants involved in financial transactions, could well be the solution to this problem. It is definitely the right method of thought – the LEI will also (with luck) exist to trace the relationships between FIs, mapping beneficial ownership and aiding in recovery and resolution planning for international corporates. The common reporting standard (CRS) is a further step in this direction – an attempt to globalise the US Foreign Account Tax Compliance Act (FATCA) in locating the citizens of home authorities holding money in low tax jurisdictions abroad, through the automatic exchange of information.
Both of these are premised on the sharing of information, the aggregation of data, and cooperation between all stakeholders. Particularly with the increasing prominence of the LEI as a reporting requirement under most upcoming regulations, uptake can only grow from here. These initiatives are a welcome step in creating the structural framework that was needed to be put in place years ago.
In the global state of play however, it does appear some reprioritising needs to take place. Capital requirements are all very well and good, but even the FSB report itself highlights how the structural causes of systemic risk are still very much at large.
It is the very lack of priority that makes information sharing and cooperation just side projects, rather than at the heart of the reform agenda. Actually prioritising regulatory harmonisation before the regulation comes out, information sharing, transparency and collaboration would benefit all market participants, with much less arbitrage, and much less risk. Although we take no delight in recognising how difficult that really is.
Despite this negativity, initiatives such as the LEI and CRS continue to sprout, simplifying a complex regulatory landscape with their increasing appearance in almost all upcoming reforms. It would be difficult not to mention the rise of Fintech and Regtech, either, which are constantly posing both disruption and opportunity to traditional banking and finance as we know it. Collaboration, dynamism, and flexibility may indeed be replacing a system taking its last few breaths.
So we are faced with a two-pronged situation. On the one hand, the structural causes of the 2009 GFC still need to be addressed; but on the other, the continually changing financial landscape is posing new challenges on a recurring basis. Financial regulation needs to address both of these issues. It is time to shift the terms of the debate from the narrow argument of more or less regulation, to thought-through, proactive and well-designed reform. A global framework for a global future; premised on what is necessary, not what is politically convenient. Intelligent regulation is the cure for a financially stable future.
It would be wise to watch the evolution of the regulatory landscape on all fronts, as for a seemingly slow process it is now changing faster than ever. Regulators with their specific authority to do so can be steering the direction of the regulatory pendulum, planning ahead, and dealing with the problems of the past. Alongside this, the platform for debate and shaping our own futures must very much be created from the bottom up.
Join that debate here.