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Beyond Basel for Banking Regulation

The financial crisis has made clear that the accumulation of risk and the occurrence of crises are almost inevitable in a self-regulated financial system governed by a framework of the Basel kind. One solution is to monitor investment banks and hedge funds and subject them to regulation while seeking an institutional solution that would protect the core of the financial structure, the banking system. The bail out implemented in the US and some of the west European countries has been forced to take a form that perhaps provides the basis for such a transformation. Governments have opted for state ownership and direct influence over decision-making. Will this be temporary or a new form of banking regulation?

HT PAREKH FINANCE COLUMN

Beyond Basel for Banking Regulation

C P Chandrasekhar

capital, risk management and disclosure at banks; and t promoting globally coordinated supervisory follow-up exercises to ensure implementation of supervisory and industry sound principles.

In short, more of the same, perhaps

The financial crisis has made clear that the accumulation of risk and the occurrence of crises are almost inevitable in a self-regulated financial system governed by a framework of the Basel kind. One solution is to monitor investment banks and hedge funds and subject them to regulation while seeking an institutional solution that would protect the core of the financial structure, the banking system. The bail out implemented in the US and some of the west European countries has been forced to take a form that perhaps provides the basis for such a transformation. Governments have opted for state ownership and direct influence over decision-making. Will this be temporary or a new form of banking regulation?

C P Chandrasekhar (cpchand@gmail.com) is with the Centre for Economic Studies and Planning, Jawaharlal Nehru University, New Delhi.

T
he financial meltdown triggered by the subprime mortgage crisis has changed the terms of the debate on financial regulation, offering an opportunity for major, even radical, reform. However all the indications are that once again the opportunity would be passed by, as happened, for instance, after the 1980s Savings and Loans crisis.

Consider, for example, the discussions that have been launched at Basel, Switzerland, on the set of undemocratically determined norms for prudential regulation of banking that countries outside the decisionmaking club have been forced to adopt.

Late last month Nout Wellink, chairman of the Basel Committee, announced plans to formulate “a comprehensive strategy to address the fundamental weaknesses revealed by the financial market crisis related to the regulation, supervision and risk management of internationally-active banks”.

The committee chairman noted, “Ultimately, our goal is to help ensure that the banking sector serves its traditional role as a shock absorber to the financial system, rather than an amplifier of risk between the financial sector and the real economy”. However, many feel that if we drop the hyperbole this amounts to nothing more than choosing to apply grease paint on a spent actor. By way of a curtain raiser all that the committee can offer are likely decisions “to strengthen capital buffers and help contain leverage in banking system arising from both on- and offbalance sheet activities”.

According to a press release from the committee, the key building blocks of the strategy would include: t strengthening the risk capture of the B asel II framework (in particular for trading book and off-balance sheet exposures); t enhancing the quality of Tier 1 capital; t strengthening counterparty credit risk with a new title such as Basel III. Coming after a crisis that showed that the Basel framework is no insurance against a crisis and in fact contributes to precipitating it by permitting banks to operate with inadequate reserves, this is an unconvincing response at best. In fact, many see it as a manoeuvre to avoid much-needed reregulation. Others see it as an exercise to s alvage the Basel framework, which some policymakers have demanded should be scrapped.

Should Basel II be restructured and r escued? At the centre of that framework was a set of beliefs on how financial markets functioned and therefore should be regulated. The first was that if norms with regard to accounting standards and disclosure were adhered to, capital provisioning, in the form of an 8% (or more) capital adequacy ratio, was an adequate means of insuring against financial failure. Second, this was to be ensured by requiring that the size of regulatory capital was computed not on the actual value of assets but on a risk-weighted proxy of that value, where risk was assessed either by rating agencies or by the banks themselves by using complex algorithms. Risk-weighting was expected to achieve two results: it would inflate the size of regulatory capital required as the share of more risky assets in the portfolio of banks rises; it would discourage banks from holding too much by way of risky assets because that would lock up capital in forms that were near-barren. Third, this whole system was to be made even more secure by allowing the market to generate instruments that helped, spread, insure or hedge against risks. These included derivatives of various kinds. Fourth, use of the framework was seen as a way of separating out segments of the financial system that should be protected from excessive risk (for example, banks, in which depositors trusted their money) and those where sections which

december 13, 2008 Economic & Political Weekly

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HT PAREKH FINANCE COLUMN

could be allowed to speculate (high net worth individuals) can legitimately do so (through hedge funds, private equity firms, and even investment banks).

Implicit in these beliefs was the idea that markets, institutions, instruments, indices and norms could be designed such that the financial system could regulate itself, getting off its back agencies that imposed structural and behavioural constraints to ensure the “soundness” of the financial system. The intervention of such agencies was seen as inimical to financial innovation and efficient provisioning of fi nancial services.

Lessons from the Crisis

What lessons has the crisis taught us about this framework? To start with, it is clear that when private players make financial decisions, limited interventions such as accounting standards, disclosure norms, behavioural guidelines and capital adequacy requirements, are inadequate restraints on the extent of risk accumulation in the system. Prudential regulation is good, but not, as the Basel framework suggested, enough. If there are no structural and behavioural constraints, such as the restrictions on cross-sector activity put in place by the Glass-Steagall Act of the US, fi nancial firms find ways of increasing p rofits by circumventing regulation. One form that this took was the transition in b anking from a buy-and-hold to originate-and-sell strategy, which allowed a geographically extensive banking system to create credit assets far in excess of what would have been the case in a more regulated system.

This had a number of implications. First, the role of banks as mere agents for generating the credit assets that could be packaged into products meant that risk was discounted at the point of origination, since banks felt that they were not holding the risks even while they were earning commissions and fees. Their capital adequacy requirements did not constrain the overhang of risk in the system they created, making Basel a poor instrument to control systemic risk exposure.

Second, a risk-weighted capital adequacy ratio (CAR) based on either ratings by p rivate firms or internal models really meant that this regulation could be diluted by “obtaining” a high rating on assets that

Economic & Political Weekly

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december 13, 2008

were risky. That this did happen is r eflected in the fact that highly rated assets were rendered worthless in a short period when the crisis began.

Third, the transition in banking meant that though banks were important from the point of view of depositors and real economy borrowers looking for short-term capital, other segments of the financial system became as or more important within the overall financial structure. The Wall Street investment banks, which epitomised financial innovation, were not banks in the conventional sense and were therefore lightly regulated and not subject to the kind of capital adequacy requirements applicable to banks. They, along with the hedge funds, private equity firms and insurance companies, came to occupy crucial intermediary positions within the financial system. Moreover, the circumvention of regulation resulted in banks, which were in search of higher returns, exposing themselves to these institutions involved in more risky and highly leveraged operations. This damaged the belief implicit in the Basel framework that regulation of banks is regulation of the core of the financial system and that guidelines which treated banks differently so as not to expose ordinary depositors to high risk were effective in cordoning off the b anking sector.

Fourth, the thirst for profit meant that the earnings of top managers were linked to the (accounting) profits their firms made, through bonuses that exceeded salaries. As a result, the appetite for risk among private decision-makers increases tremendously. What was introduced as an incentive for performance became an i ncentive to speculate.

Fifth, so long as fully private players adopted these aggressive strategies, even government sponsored entities and public banks had to follow this route if they were not to lose their business to private p layers. Public or quasi-public ownership became meaningless from the point of view of r egulating behaviour. Nothing illustrated this more than the fate of Fannie Mae and Freddie Mac, the quasi-public housing mortgage agencies in the US.

Sixth, the freedom to innovate resulted in maturity mismatches in the system, as was true, for example, of auction rate s ecurities, which used liquid short-term funding for long-term purposes. When l iquidity froze, those who were convinced that they were holding liquid securities found them to be illiquid, worsening the crisis. That is, innovation increased the a reas of vulnerability.

Finally, capital adequacy proved meaningless when the crisis came because l osses stemming from this structure of a sset holding were adequate to wipe out the capital base that had been provided for by many banks, necessitating equity infusion and nationalisation.

Risks under Self-Regulation

These lessons from the ongoing financial crisis make clear that the accumulation of risk and the occurrence of crises are almost inevitable in a self-regulated financial system governed by a framework of the Basel kind. Limited intervention cannot fundamentally alter financial behaviour to avoid such an outcome. Strong regulation is called for. One form that such regulation can take is that which was put in place by the Glass-Steagall Act. This in itself may not be a full solution today, and there could be contexts where a degree of financial integration could play a role. In particular, countries which want to use the financial structure as an instrument to further broad-based growth may need to opt for universal banks that follow unconventional lending strategies, when compared with the typical commercial bank.

Thus, setting up Chinese Walls separating various segments of the financial sector may not be the best option. Nor can investment banks and hedge funds be abolished. What could, however, be done is to m onitor investment banks and hedge funds and subject them to regulation, while seeking an institutional solution that would protect the core of the financial structure: the banking system. The current bail out being carried out in the United States has been forced to take a form which perhaps provides the basis for such a transformation. After much dithering, governments in the developed industrial countries have opted for state ownership and direct influence over decisionmaking. Whether this would be temporary or the basis of a new form of banking regulations is yet to be seen.

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