Corporate Advisory

Financial Market Reform – We ask the big questions

The general prognosis for the US financial regulation appears at best extremely poor at the moment. Here we ask four questions we feel important about the structural reform that needs to be answered to get regulation and reform in general back on track. The sector doesn’t really want to wait for the next disaster to promote lasting and transformational change.

The recent publication by the Volcker Alliance of a series of papers on reforming the financial regulatory structure makes interesting reading. You may or may not agree with their conclusions, but I, for one, can’t help but think that there are some important questions about structural reform lurking just under the surface that were either not asked or were subsumed in these papers. So let’s get them out on the table and see where they lead us.

Should a central bank be the primary banking regulator?

The Volcker Alliance documents recommend that the primary banking regulator be the Fed. But we need to look closely at the functions of a central bank and a banking regulator, to see if that combination really works.

To begin with, a central bank must be, by definition, a bank. That sounds obvious, but it has one or two subtle implications. The first is that, in the modern world, 99.99% of money is actually a bank’s promise to pay. And every commercial bank’s promises to pay are offset by the central bank’s promise to pay. So all these institutions are tied together in a web. Whether the entanglements of that web make it harder for a central bank to act as a truly independent banking regulator is open to debate, but we probably need a healthy public discussion of that topic, for a start.

Then, we have to recognize that most central banks are also lenders of last resort, generally to the banks in their system. Here it is important to understand that the last resort function only happens in a crisis, but the potential is there all the time. If the regulator is doing its job well, the last resort function usually remains just a concept, but events that aren’t within the purview of the regulator, such as the actions of another country’s regulator, can bring on a crisis in a hurry. If that happens, is it better to have the banking regulator separate from the lender of last resort? Another topic for discussion.

Finally, central banks have a set of functions that require them to be active in the markets, like controlling interest rates and currency values. These functions especially require them to deal as principal (and sometimes as agent) in these markets, often trading with the banks in their system. Thus we could easily see instances where the central bank as monetary authority is dealing with a bank in one way, and the banking regulator is dealing with the same bank in another way. Whether the needs of the central bank as market operator might trump the needs of the central bank as regulator is another subject for discussion.

There are countries, of course, where the only regulator of the banking system is the central bank, but those countries may not have the same political or economic framework the US does. In any event, if we are going to restructure financial regulation in the US, we need to answer this question first.

How should we define market regulation and depository regulation?

A variation of this question has often been discussed, in the form of combining the two market regulators in the US. Since the US are the only country with separate regulators for securities and commodities, the Volcker Alliance recommendations are to combine the SEC and CFTC, to nobody’s surprise. Have one banking regulator, and one market regulator, so the logic goes.

But there is another, perhaps more relevant question. Should we instead place the depository functions of both banks and brokers under depository regulation, and the market functions of those same institutions under a market regulator? Should we have one regulator charged with protecting, in effect, both checking and trading deposits, and another regulator requiring all market participants, large and small, including clearinghouses, to act professionally and prudently?

The idea that one depository regulator would oversee both a bank and a brokerage firm may sound strange, but it is more palatable if we define regulation along functional as opposed to organisational lines. The recent experience with such requirements as Volcker Rule examinations has shown us that the expertise necessary for depository regulation doesn’t usually translate well into regulation of principal trading functions, and vice versa. To the extent that deposits are insured, as they are in both banking and brokerage, the regulation of deposit takers is essentially the same across both industries. And the surveillance of market participants, whether they are trading for their own account or for others, is homogeneous enough to be handled by one regulator across all market participants.

There are, of course, lots of discussion points here. This would require two regulators for all entities that both take deposits and trade in markets, but most financial institutions have more than one regulator anyway. This structure would preclude what we currently see in Volcker Rule exams, the folly of having five sets of examiners, the Fed, the OCC, the FDIC, the SEC, and the CFTC, all trying to come up to speed on what is essentially the same subject. If asked, most financial institutions would probably prefer to have one regulator knowledgeable in their depository functions and one knowledgeable in their market functions, as opposed to several regulators trying to handle both functions.

How important is international symmetry in regulation?

There has been discussion about international asymmetry in financial regulation for as long as I can remember, perhaps as far back as Walter Bagehot (you could look look him up). Even then, the crux of the matter was regulatory arbitrage. Long ago, it was about moving physical money and assets into venues where regulation was more lax or out of date. Today it’s about moving transactions or funds electronically between venues for the same purpose.

As it turns out, there are other reasons to move transactions between venues, such as tax and counterparty location, so every intra-company cross-border trade isn’t a regulatory arbitrage. On the other hand, cases like AIGFP, where trades done in London by a French-chartered company resulted in a $150+ billion Fed bailout of a US insurance company, show that regulatory arbitrage can have some very significant impacts, in particular the kind of “blow-back” danger we saw in AIGFP. In the ongoing regulatory conversations about the implementation of the Pittsburgh G-20 agreement, there have been some sharp words exchanged about regulatory practices that led to blow-backs.

Thus it is a good idea to prioritize the regulatory asymmetries that would promote the kind of arbitrage that could result in blow-back, while placing less importance on asymmetries that would keep the problems contained in the venue where they began. The area of most interest today is the recognition and regulation of derivative clearing houses. Since the implementation of the G-20 agreement is generally recognized to have greatly concentrated the risk in the derivatives market, perhaps the most important international symmetry concerns CCPs. The main Volcker report only mentions clearinghouses once, in passing, and the national case studies not at all. Given the amount of attention being paid to the international regulation of CCPs, that’s an important omission that makes the report look a bit out of date

Is this all just a waste of time?

The Volcker Alliance report laments, and everyone is probably aware of, the many unsuccessful attempts to streamline financial regulation in the US. If most impartial observers recognize that US financial regulation is decidedly sub-optimal, and that the structure is at least partly to blame, we need a clear understanding of why that structure persists.

Perhaps we can start the explanation with this quote from the report, which is itself a quote from the Financial Times: “Former Senator Chris Dodd echoed that sentiment in a speech last year, ‘I would’ve established a single prudential regulator and gotten rid of the rest,’ he said. But, he added, ‘I got about three votes at the time.’” That leads to the immediate question of why such an obvious improvement would be so unpopular in the halls of Congress.

That may sound like a naïve question, but it’s really not. If the members of Congress have enough intelligence to understand the benefits of such a change, then the only explanation I can see is that the financial industry has so much influence over Congress that it can stop this kind of reform in its tracks. Assuming that this isn’t a case of blackmail, then it can only be a case of money, perhaps suitcases of money.

If that logic is correct, and I’m anxious for it to be proven wrong, then the prognosis for financial regulation in the US is very poor. If financial institutions can – pardon the expression – bank on a fragmented regulatory structure to give them the freedom they want, then we just have to wait patiently for the next financial disaster. In that case, the Volcker Alliance documents might make interesting history someday, but not public policy today.