The 3 Cs of financial regulation
10 years ago at a seminar with international financial officials, Timothy Geithner, who was then President of the New York Federal Reserve, referred to the financial crisis that had just hit the United States in past tense, wrongly assuming that the worst was over.
In his 2015 book Stress Test: Reflections on Financial Crises, Mr. Geithner corrected himself and called the events of late 2007, which included the near collapse of the largest mortgage lender in the US, “left of the boom”, a term used to describe the time before an improvised explosive device actually explodes.
The unprecedented devastation of the financial sector the following year, beginning in the United States (US) and quickly spreading across the world caught regulators off guard and ended up destroying countless lives.
To prevent the next crisis, regulators need to have oversight of the entire financial system, and a simple governance structure with clear lines of accountability.
The Big Short, a movie detailing the global financial crisis, ends on an ominous note highlighting that the much-maligned Collateralised Debt Obligation (CDO) instrument (that was at the heart of the subprime mortgage lending that caused the global financial crisis) was still masquerading as a “bespoke tranche opportunity” in 2015.
Regulation cannot prevent the evolution of financial products. The key, instead, is for regulators to have the foresight to predict the next bubble that could bring down the entire economy and burst it in its infancy.
Mr Geithner, who went on to help President Barack Obama battle the financial crisis as his Treasury Secretary, reflected later that the “current oversight regime (in the US) was a ludicrously balkanized mess”.
While the formation of the Financial Stability Oversight Council (FSOC) in 2010 was a step in the right direction, it still only has, in its own words, “collective accountability” for identifying risks and responding to emerging threats to financial stability.
Consolidating and streamlining regulatory functions would have seemed logical after the global financial crisis exposed how vital signs were missed and leverage was allowed to pile up outside the traditional banking sector.
However, a decade later, the Securities and Exchange Commission and the Commodity Futures Trading Commission in the US remain separate despite significant overlap in their mandate. Similarly, regulation of depository institutions remains split between the Office of the Comptroller of the Currency, Federal Deposit Insurance Cooperation and Office of Thrift Supervision.
As Mr Geithner frankly put it, while combining these agencies made regulatory sense to almost everybody, they were “political non-starters” because of partisan interests and the fear of losing out on political donations from the respective industry lobbying groups.
CONSOLIDATE, COORDINATE, COLLABORATE
A working model of a streamlined and consolidated financial regulatory system may come from Singapore or Australia.
In Singapore, the entire financial sector is regulated by one entity, the Monetary Authority of Singapore (MAS). In addition, MAS is also a central bank and in charge of developing the financial industry.
MAS is also one of the few central banks and financial regulators in the world that sit very much within government, as a statutory body reporting directly to the Prime Minister. MAS Managing Director Ravi Menon revealed how the World Bank was “horrified” when the Singapore Government first decided to appoint a cabinet minister as MAS’ first chairman as it was akin to “asking the cat to look after the fish”.
However, successive governments have made the arrangement work by being fiscally responsible and not interfering in MAS’ day to day affairs.
While the arrangement has its drawbacks, such as the risk of MAS becoming politicised or succumbing to groupthink, it gives MAS a broad view of the system and the powers to respond to a crisis while avoiding regulatory capture that can be found in a sectoral model.
Meanwhile, Australia has a twin peak model with the Australian Securities and Investment Commission and the Australian Prudential Regulation Authority leading the charge while the Reserve Bank of Australia (RBA) remains partly responsible for financial system stability by serving as the lender of last resort. The Council of Financial Regulators, chaired by the RBA and which also includes the government’s Treasury Department, coordinates the work of the regulatory agencies to maintain overall financial system stability.
While by no means a panacea, this arrangement gives Australia the advantage of having consolidated regulators who have a broad view of the system while avoiding regulatory capture that can be found in the sectoral model or even groupthink that might affect a super-regulator. In any case, cooperation between the different players rather than conflict underpins the success of any model.
Unsurprisingly, during the 2008 financial crisis, countries like Australia and Singapore found themselves a step ahead in their response. Subsequently, many economists encouraged greater collaboration between central banks, regulatory authorities and the government to maintain financial stability and respond quickly in the event of a crisis.
The UK has since abolished its Financial Services Authority, which was criticised for its brand of “light touch” regulation prior to the financial crisis. The Bank of England has once again been put in charge of financial stability through its powerful Financial Policy Committee, which oversees and can instruct the two new regulators, the Prudential Regulation Authority and Financial Conduct Authority set up in 2013. This allows the central bank to play a much larger role in the functioning of the financial system.
Good regulation that prevents a crisis always has the perverse effect of introducing complacency, as seen by the Trump administration’s plan to dismantle the Dodd-Frank Act which established the FSOC and introduced other stringent regulations.
A decade later, as memories of the global financial crisis fade, lawmakers would do well to remember the old adage that prevention is better than cure.
Given that many middle-class families lost their retirement savings and homes because of unscrupulous financial institutions, preventing the next financial crisis would be more equitable too.
This article first appeared in the Commentary (Op-ed) section of the TODAY newspaper in Singapore on 1 November 2017. A link to the original article is as follows: http://www.todayonline.com/commentary/3-cs-financial-regulation
