ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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Obama Ducks the Banking Challenge

The US has followed a cautious approach in tackling the current crisis in banking. It has refused to tackle the crisis head on, it has instead followed an "endure and wait" approach. What of preventing future crises through regulatory reform? The Obama administration's proposals to prevent another banking crisis are just as tepid and refuse to grasp the nettle in a number of areas - in preventing concentration, containing compensation levels and dealing with important human resources issues. The US Treasury proposals do not give the impression of going far enough in tackling the issues highlighted in the present crisis.

H T PAREKH FINANCE COLUMN

Obama Ducks the Banking Challenge

T T Ram Mohan

These are outcomes that the US administration does not seem to favour. It prefers to muddle through by relaxing accounting rules so that losses are reduced, providing capital that does not result in government ownership and let-

The US has followed a cautious approach in tackling the current crisis in banking. It has refused to tackle the crisis head on, it has instead followed an “endure and wait” approach. What of preventing future crises through regulatory reform? The Obama administration’s proposals to prevent another banking crisis are just as tepid and refuse to grasp the nettle in a number of areas

– in preventing concentration, containing compensation levels and dealing with important human resources issues. The US Treasury proposals do not give the impression of going far enough in tackling the issues highlighted in the present crisis.

T T Ram Mohan (ttr@iimahd.ernet.in) is with the Indian Institute of Management, Ahmedabad.

R
emember that catch phrase of the late 1990s “new financial architecture”? Everybody talked about it following the east Asian crisis. The moment the crisis died down, the expression and the lofty intent behind it fell by the wayside.

Are we about to see something similar in respect of banking sector reform? There has been a flurry of reports on how to overhaul the banking and financial sector. The United States (US) Treasury came out with a proposal for regulatory reform in June. In the United Kingdom (UK), the Financial Services Authority head, Adair Turner, published a report and a discussion paper in March, followed by the UK Treasury’s proposal for reform in July. The European Union unveiled proposals for bank capital in July. There have been reports from independent committees and think tanks as well.

If the Obama administration’s approach thus far is any guide, it appears likely that talk of banking sector reform will largely remain just that – talk. The US response to the ongoing banking crisis thus far has been tepid. The central challenge in a crisis situation is to recognise banking losses and ensure that banks get the necessary capital – if not from private sources, then from government. This is the only way that we can prevent serious disruptions of credit flows and a serious downturn in the economy.

Absence of Determined Response

One reason the present financial crisis has turned out to be more acute than thought earlier is that this sort of determined response to the crisis has not been forthcoming in the US. Recognising losses at one go would wipe out shareholders in many of the bigger banks and it would also mean that the US government would have to infuse capital to an extent where it becomes the majority owners of these banks.

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ting incremental bank profits absorb losses over time. But, bank losses are so large that this approach ensues that the resolution of banks’ problems will stretch over at least two years – and, in that period, credit flows will be impaired. The US and hence global economy recovery will be delayed to that extent. So be it, if that is the price to be paid for avoiding even temporary government ownership – this is the Obama administration’s approach.

It does look as though the present crisis cannot be cured, it must be endured. What of preventing future crises through regulatory reform? The US Treasury proposals do not give the impression of going far enough in tackling the issues highlighted in the present crisis.

Changing the Structure

Much of the focus of US regulatory reform is on changing its structure. America has long had multiple regulators watching over the financial system, with the roles of f ederal and state agencies often overlapping. One federal regulator, the one for thrifts, will be eliminated under the new proposals but two new ones will spring up: a National Bank Supervisor (NBS) that will supervise federally chartered banks and a Consumer Financial Protection Agency (CFPA) to protect the interests of consumers. The new proposals will leave in place four federal regulators, several state regulators and the CFPA. The Federal Reserve is to be vested with the authority to supervise all systemically important institutions, including non-bank institutions. A new Financial Servi ces Oversight Council, a body of regulators, will be created to identify emerging systemic risks and to improve interagency cooperation.

Whether the reshuffling of regulatory roles and creation of new agencies will make for better regulation only time can tell. But one thing can be said with confidence: the problem in the US and in other places is not the absence of regulation but

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Economic & Political Weekly

H T PAREKH FINANCE COLUMN

lax enforcement. This has happened partly because regulators, no less than bankers, tend to get carried away in times of irrational exuberance. It takes great courage to slam the brakes in such periods.

But, also, there is the problem of regulatory capture, regulators becoming too friendly towards corporate and other interests. The enormous chasm between regulators’ compensation and those of bankers gives rise to the revolving-door syndrome, that is, regulators moving on to private firms and, often, moving back to regulatory agencies. It is hard to expect tough enforcement of regulation or tight situation, given these acute conflicts of interest.

It is not as if systemic risks could not have been identified in the present regulatory structure. Nor is a separate agency needed for consumer protection. Perhaps, consumer protection can be better done by requiring approval for certain products and by putting in place the Ombudsman scheme that we have in India and that is reasonably effective in handling customer complaints.

Dealing with HRD Issues

So, the answer is not new agencies. It is containing conflicts of interest that are rife in regulatory agencies in the US and, equally important, making a career in regulation satisfying. In other words, the focus has to be not the proliferation of regulatory agencies but tackling the HRD issues in these agencies. Of this, the US Treasury paper shows little awareness.

A key feature of the Treasury paper, as it is in the approaches to bank regulation elsewhere following the financial crisis, is tougher capital requirements for banks. The paper proposes higher capital requirements for large, interconnected institutions. Capital requirements will be countercyclical, encouraging institutions to have enough capital in good times to offset declines in capital in bad times. Capital requirements for banks in general will be reviewed. There will be rigorous liquidity risk requirements for large institutions but it is not clear if this means additional capital to cover liquidity risk.

But none of this will happen quickly. The conclusions about capital requirements for banks arrived at by a working group will become available only in December 2009. Imposition of the new capital requirements

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AUGUST 8, 2009

is unlikely to happen before the US economy shows clear signs of recovery. Moreover, it will be difficult for any regulator to impose tougher capital requirements for its banks without broad agreement among regulators across the world on such requirements. In other words, the tougher capital requirements are all in the future. By that time, banks will have recovered and reform-weariness will have set in. So, one is not sure how tough the new capital requirements will be.

Too-Big-To-Fail Problem

One of the most important challenges in banking reform is tackling the too-big-tofail problem. How do we deal with the threat to stability created by large institutions? Managers at these institutions know that they will not be allowed to fail, so they have every incentive to take excessive risk. Bigness becomes a licence for managers to do as they please.

Capital requirements that rise with size are one solution but they cannot be the whole of the solution. That is because however tough the new capital requirements are, banks will continue to be highly leveraged by general standards. Higher capital does not quite solve the too-big-tofail problem, it only mitigates it. Neither in the US nor in the UK is there a willingness today to grasp this basic truth.

There are two more direct ways of addressing the too-big-to-fail problem. One is by reducing the scope of activities of large banks, say, by separating commercial banking from investment banking. On this opinion is divided; many think that valuable synergies will be lost if this is done. The other is to put a cap on the size of banks, say, by stipulating that no bank’s assets should be more than a certain percentage of GDP. But this is not the approach the US Treasury favours. Its approach is to have a resolution regime for large banks put in place in advance. As is well known, once a crisis happens, it is impossible to shut down a large bank.

So, the big lacuna in the US Treasury paper is the reluctance to grasp the nettle when it comes to systemically large institutions. As the Bank for International Settlements notes in its latest Annual Report, there is every likelihood that the problem is being worsened in the short run because of

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the dire need to stabilise the financial system by merging weak banks with larger ones.

The report notes that “rescue packages are building up financial sector concentration and systemic risk even as reforms in regulatory policy seek to make those risks more manageable”. In the US, two of the investment banking survivors, Goldman Sachs and JP Morgan, have reported stellar profits for the second quarter partly by grabbing some of the market share of their deceased or disabled rivals.

Compensation Levels

We are also seeing a quick return in the US and elsewhere to outsized bonus packets and extravagant base pay. The US Treasury paper talks of incentives being properly aligned and giving shareholders a greater say in the determination of pay. But the idea that better governance will rein in pay that encourages excessive risk-taking seems highly flawed: the market seems incapable of righting these excesses.

So, there is really no alternative to some regulatory checks on pay. The regulator must, at the least, be empowered to penalise flawed compensation practices through additional capital requirements. It may also be necessary for the regulator to have veto powers over levels of executive pay in banking. The Reserve Bank of India has these powers and has not hesitated to use them as required. Again, the will to tackle this problem seems to be missing in the US.

There are other areas where the paper seems to pull its punches. Rating agencies are to be better regulated but concrete proposals for better regulation (such as getting exchanges to pay the agencies instead of the customers who get rated) are missing; securitised loans will require originators to hold 5%, whereas a higher proportion may be merited in certain types of securitisation; there will be higher capital charges on derivatives traded over the counter but no requirement that certain derivatives must be traded only through exchanges.

Even these limited proposals have to go through the US Congress for approval. This process is expected to take another year and one can expect bank lobbies to have some of them watered down. What shape banking sector reform will eventually take and how effective this will turn out to be is anybody’s guess.

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