There have been a number of commissions and committees on the financial crisis over the past year, which have largely covered the same ground in their analysis and recommendations for reform of the financial sector. The Warwick Commission on International Financial Reform, constituted by the University of Warwick in the United Kingdom, however, strikes out on a different path. It raises a number of issues in a way that many other reports have not. And it also differs sharply in some of the recommendations it makes. This article highlights four themes that figure in the report: macro-prudential regulation, rightsizing the financial sector, regulatory capture and home country versus host country regulation.

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Post-Crisis Regulation: A Contrarian Perspective

T T Ram Mohan

There have been a number of commissions and committees on the ﬁnancial crisis over the past year, which have largely covered the same ground in their analysis and recommendations for reform of the ﬁnancial sector. The Warwick Commission on International Financial Reform, constituted by the University of Warwick in the United Kingdom, however, strikes out on a different path. It raises a number of issues in a way that many other reports have not. And it also differs sharply in some of the recommendations it makes. This article highlights four themes that ﬁgure in the report: macroprudential regulation, rightsizing the ﬁnancial sector, regulatory capture and home country versus host country regulation.

The Reserve Bank of India’s approach has been in line with much of the Warwick Commission’s recommendation and the latter, in turn, are quite different from what the Percy Mistry and Raghuram Rajan Committees put out for India.

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

here is no dearth of committee reports on the sub-prime crisis. To mention a few: the Turner report in the United Kingdom (UK), the UK Treasury’s report, the United States (US) Treasury’s report, the Financial Stability Forum report, the report of the Stiglitz Commission constituted by the United Nations (UN) and the UNCTAD report. With the exception of the Stiglitz Commission (whose range of concerns is wider), these reports largely cover the same ground and their diagnosis and prescriptions have much in common.

So, I approached the November 2009 report of the Warwick Commission on International Financial Reform, constituted by the University of Warwick, with a certain lack of enthusiasm. Almost everything that needed to be said has been said. What more could they say? True, the commission had more academics and representatives of think tanks on board than many other committees. But one was not sure this was necessarily a virtue in an area in which application is everything.

I am happy to say that my misgivings turned out to be misplaced. The Warwick Commission does have fresh perspectives to offer. It raises a number of issues in a way that many other reports have not. And it also differs sharply in some of the recommendations it makes. In this article, I propose to highlight some of the themes that ﬁgure in the report: macro-prudential regulation, rightsizing the ﬁnancial sector, regulatory capture and home country versus host country regulation.

Macro-Prudential Regulation

There is general agreement now that it is not enough to get the rules for banks and other ﬁnancial institutions right. Even if this is done, the system could be exposed to risk. Worse, systemic risk could be high precisely on account of micro-prudential regulation. This arises because of h omogeneity in the ﬁnancial system. Homogeneity, in turn, is the result of several factors: the use of market prices as a measure of risk, failure to take into account funding and leverage in setting rules for capital, and not distinguishing between various types of risk.

Take the problem with the use of market prices as measures of risk, a problem with which we have become only too familiar in the present crisis. If all players are required to use mark-to-market accounting, then all will want to sell when the price of particular assets fall. This sets in motion a downward spiral in asset prices and leads to a huge erosion in capital in the ﬁnancial system during a crisis. Similarly, the use of market measures of risk leads to herd behaviour in good times as all participants want to hold assets that were regarded as safe in the past. Such herd behaviour then makes the assets overvalued, risky and correlated with other assets of investors.

How do we tackle this problem? We have heard much about making regulations counter-cyclical. This would put the brakes on herd behaviour in ﬁnancial institutions.

The novel proposal that the Warwick Commission makes is to have different rules for different players in the ﬁnancial system. Banks use short-term funding and may be subjected to mark-to-market accounting. Others, such as insurance ﬁrms, use longerterm funding and should be allowed to judge whether it makes sense for them to buy assets that banks want to get rid of.

Using the same accounting rules for both types of players does not help in a crisis situation. Rather, the commission urges, regulations must move particular risks to institutions best capable of holding them. This is indeed a bold departure from the conventional wisdom which is to set store by a “level playing ﬁeld” for all players. More on this later.

Homogeneity in the ﬁnancial system today also arises from the failure to take into account differences in funding and leverage. An institution that is heavily dependent on short-term funds from the capital markets has the same capital requirements as another that relies on deposits. The commission proposes capital requirements that are linked to mismatches in maturities between assets and liabilities. This, however, is not something that has thus far found favour with the Basel Committee.

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There is one aspect of homogeneity that does not seem to have got the attention it deserves: homogeneity in ownership. Or, to put it differently, the potential beneﬁts in terms of managing systemic risk of having different kinds of ownership in the ﬁnancial sector. India and China both have this sort of heterogeneity, more so India.

We have a public sector-dominated banking sector, a fairly large room for the domestic private sector and lesser scope for the foreign sector. Their respective shares will, of course, change over time and it is possible to debate how fast this should happen. The crucial point is that the system seems to gain from having a diverse mix of ownership probably because the attitudes towards risk differ among the different owners.

Public sector banks are relatively riskaverse; foreign banks, perhaps, come in at the opposite end of the spectrum. The system as a whole avoids either extreme. In risk management, there is the regulatory issue of ensuring that all players do not use the same models because this makes for identical responses in a crisis. Can we extrapolate from this and say that the same argument holds with the pattern of ownership in banking? The Warwick Commission might have addressed this issue.

There is one signiﬁcant aspect of macroprudential regulation that the report does not touch upon: the role of monetary policy in dealing with asset bubbles. Should central banks respond to signs of asset bubbles? Is there a range for asset prices that central banks should target? These are issues that have ﬁgured in public discourse on the ﬁnancial crisis.

Rightsizing the Financial Sector

I turn now to another important issue ﬂagged in the report, namely, the size of the ﬁnancial sector in relation to the real economy. The ﬁnancial crisis has thrown the spotlight on how bloated the ﬁnancial sector had become in economies such as the US and the UK and how certain m arkets, such as foreign exchange, bore no relationship to the real economy.

The Warwick Commission sees a clear need to rightsize ﬁnance. It also raises an important research issue that needs to be pursued: is there an optimal size for the ﬁnancial sector? Finance should not be so small that it constrains the real economy; it should not be so large that an inevitable shrinkage at a later point has an adverse impact on the real economy.

What caused the ﬁnancial sectors in the advanced economies to become so bloated? The report mentions several factors. One, the belief that the ﬁnancial sector is the most efﬁcient allocator of resources and hence the more developed the ﬁnancial sector, the better for the economy. Two, the growth of investment banks and brokers who, it was thought, performed the role of resource allocation without putting the ordinary depositor at risk. Three, the view that market participants had developed sophisticated models that helped them monitor and manage risk effectively.

How to prevent the ﬁnancial sector from being bloated? The report mentions means that have been proposed by others as well: counter-cyclical provisioning norms, mandating a ceiling on the leverage ratio for ﬁnancial institutions, higher capital requirements for systemically important institutions, and a Tobin tax to limit shortterm activity in the ﬁnancial markets. The ﬁfth idea is the commission’s own: segregating different categories of ﬁnance, based on risk capacity, and moving away from a level playing ﬁeld for all institutions. Former US Federal Reserve Chairman Paul Volcker, Bank of England governor Mervyn King and former US Treasury Secretary Nicholas Brady are among those who have urged restrictions on the scope of activities of ﬁnancial institutions. They would like to see a clear separation of banking from investment banking activities in order to prevent a recurrence of ﬁnancial crises. Others have argued for restrictions on the size of ﬁnancial institutions.

The commission believes that a better way to handle the problem is not to have the same regulations across various types of institutions. Having an un-level playing ﬁeld, they contend, will in itself prevent the emergence of ﬁnancial supermarkets and the too-big-to-fail problem. This is an idea that is worth exploring because, if feasible, it could be an alternative to blunt instruments such as restrictions on scope and size.

Regulatory Capture

The Warwick Commission is forthright in laying the blame for the ﬁnancial crisis where it belongs. It says, “Regulatory capture

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substantially contributed to regulatory failure”. It makes the point that regulatory capture was not just a matter of market players coming to exercise inﬂuence.

Regulatory capture was also intellectual. There was a universal acceptance of notions of market efﬁciency and the consequent need for regulation with a light touch. There is also the in-built reluctance of politicians to cut off a boom – who wants to put an end to the good times?

The report draws attention to an insidious trend that we in India also need to be alert to: a growing role for the private sector in policy formulation. There is a line to be drawn always between taking inputs from the private sector – and both the Reserve Bank of India (RBI) and the Securities Exchange Board of India (SEBI) do a good job of this – and giving them a role in formulating policy.

The report makes three concrete suggestions for containing regulatory capture. One, regulatory policy should be more rule-based. Two, the ﬁnancial sector and ﬁnancial institutions should be rightsized so that they do not wield disproportionate clout when it comes to making policy. Three, we should emphasise host-country rather than homecountry regulation. This is especially necessary for emerging market economies to have room to deal with cross-border ﬂows.

Home Country versus Host Country Regulation

Perhaps the most contrarian recommendation of the report is that the locus of regulation should be host-country regulation and not home-country regulation. The conventional wisdom underpinning the various Basel agreements tends to stress global rules in the name of creating a level playing ﬁeld for players and preventing regulatory arbitrage. The commission makes the telling point that the present system, with its global orientation, could not ultimately prevent regulatory arbitrage.

The reality is that national regulators may sign up to global agreements but will ultimately do their best to favour their own institutions – witness the expansion of US investment banks into Asia after the east Asian crisis, “light touch” regulation in Britain, etc. Besides, global rules just

cannot meet the requirements of individual countries because countries differ in their ﬁnancial structure. They also differ in their political priorities. In India, the focus on ﬁnancial inclusion is appropriate. Transplant this to the US and you may end up having lax regulation for the section of society that needs it most, as we saw in the sub-prime crisis.

The report states its alternative proposal in emphatic terms:

The idea is that all institutions carrying on ﬁnancial activities nationally, raising funds from residents or investing in national assets or markets, must be regulated locally. An I celandic bank could no longer operate in the UK as a branch, regulated in most party by the authorities in Iceland but must be regulated in the UK as a stand-alone bank with sufﬁcient capital for its activities in the UK and be able to withstand the failure of its parent.

Does this imply that a subsidiary of a foreign bank will be subject to the same treatment as a domestic bank? The report suggests this would indeed be the case. Such a prescription, however, is open to question.

In India, the RBI permits foreign banks to operate either as branches or as subsidiaries. But subsidiaries of foreign banks do not qualify for the same treatment as domestic banks. This is because a host of issues related to the regulation of foreign banks do not go away just because they operate through subsidiaries. The report mentions the stability of the Indian banking sector as highlighting the advantages of host country regulation, so it would have been appropriate for the commission to have taken note of the nuances to foreign bank regulation in India.

I would argue that it may not sufﬁce to stop at having foreign banks operate as subsidiaries. To ensure a better convergence with host country interests, it may be necessary to require subsidiaries to list on exchanges with a requirement that, say, 40% of capital be offered to host country investors.

To sum up, we in India will not have difﬁculty in going along with the thrust of this report and indeed will be pleased with what it says because on issues such as macro-prudential regulation and host country regulation, the RBI has turned out to be ahead of the regulatory curve and in line with what the report r ecommends.

The Percy Mistry report on Mumbai as an international ﬁnancial centre viewed a span king ﬁnancial district as central to powe ring economic growth. India’s growth record in 2004-08 has helped debunk this view. The Warwick Commission’s emphasis on rightsizing ﬁnance should help place the issue in better perspective. The Raghuram Rajan Committee report found fault with the absence of a level playing ﬁeld amongst different ﬁnancial intermediaries in the Indian system. The Warwick Commission report should prompt some serious rethinking on this issue as well.

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