The global regulatory reforms

THINK ASIAN
BY ANDREW SHENG

JUST as the US appears to have reached an agreement on their banking financial sector reforms, the Euro-Greek crisis broke out.

In April, two important consultations on the Basel Committee on Banking Supervision’s proposals for the reform of bank capital and liquidity requirements ended, just as the banking lobby around the world furiously pushed back the suggested reforms in different ways.

After having carefully read the proposals, I have formed two conclusions. Firstly, I am not sure that the global proposals will prevent the next crisis. Secondly, I do not think that all the proposals fit the needs of the emerging markets.

Everyone is waiting for the World Cup Football matches in South Africa. What you are seeing in the rule changes can be likened to a football referee, who after witnessing a collapse of the game where everyone has broken the rules, asks that the goalpost be shifted.

Insufficient enforcement

This crisis did not happen because the rules were defective (some were), but because there was insufficient enforcement of the existing rules.

If you say that Basel II rules were good enough to prevent a major crisis in Japan, which had implemented the rules, then why didn’t it also prevent the crisis in the US, UK and Europe?

The answer is that no one there enforced Basel II. The whole basis for Basel II was capital efficiency, not capital adequacy.

After the crisis, people were shocked that all the complex rules boiled down to was 2% core capital against markets that moved more than 5% a day and a liquidity of 1% of total assets.

When the crisis came, the central bankers became lenders of first resort, not lenders of last resort. The emperor had no clothes and the banking system, as Alan Greenspan reminded Asia in 1999, had no spare tire.

Why is the banking industry in the West so much against such rules? The answer is that the low capital adequacy (in fact high leverage) was exactly the reason why bankers were getting such large salaries – the more short-term profits they appeared to get, the higher the bonuses and the larger the bailout that the taxpayers have to fork out.

We now agree that banks should not be too large to fail. But the Greek rescue means that for countries that are members of larger unions are also “too small to fail”.

So we have a situation that under the present system, no one is allowed to fail. The issue is very simple. Everyone who eats a pound of delicious French fries knows that it is “short-term gain, long-term pain.” If you become overweight, you will pay through weak health and more hospital bills.

Anyone who tries to diet will understand that it is all about “short-term pain, long-term gain.”
Financial regulation and supervision means that you prevent crisis by taking small steps all the time by enforcing the rules. Small and immediate enforcement can help to prevent big crisis.

Big problems have small origins. If the football referee does not enforce the rules, are we surprised that the game becomes totally uncontrollable?

The second issue is moral hazard. The first basis of financial regulation is that it must be easy to understand, learn, use and enforce. This is why we have principles–based regulation.
However, those who are regulated prefer to have rules-based regulation. This means that rules are made more and more complex, as the market demands that this and that are exempted from the rule or the calculation.
For example, the 8% capital adequacy rule is diluted through many gimmicks. First, the capital adequacy ratio is calculated as the numerator (capital) divided by the denominator (the asset or liability).

The numerator can be changed or diluted in many ways, such as Tier 2 capital, using subordinated debt or unrealised profit from unsold stocks held by the bank.

The core capital (paid-in capital plus retained earnings) is weakened from 8% to less than 2% by these classifications.

The second gimmick is to change the denominator. Instead of strict and simple calculation like total assets or liabilities (including contingent liabilities or those below the line), banks were permitted to use risk-weighted assets.
 
For example, sovereign bonds were given zero weighting if they had investment grade rating by the rating agencies. Look what has happened with Greek bonds, which can be downgraded overnight to junk bond status. Even mortgages were given very low risk ratings.

The third gimmick is the shifting of liabilities off-balance sheet so that they do not require capital. This is the main effect of creating derivatives so that liabilities become contingent.
Now we know that in a systemic crisis, contingent liabilities have a habit of getting back into the balance sheet.

The fourth gimmick is to persuade regulators that sophisticated investment bankers can rely on their internal risk models to measure risks.

The fifth gimmick is to move liabilities offshore completely beyond the regulation of the home regulator.
This was the creation of the shadow banking system, where one is lightly or not regulated at all. These gimmicks mean that for every rule, there are at least five ways of going around the rules.

Moral hazard

However, the more complex the rule, the easier it is to escape them and the greater the moral hazard that the state would have to end up paying for.

When people do not understand the rules, they blame the rule maker, not the rule breaker.
The Basel Committee has decided that there are five major areas of reform:

·The quality, consistency and transparency of the capital base will be raised;

·The risk coverage of the capital will be strengthened, avoiding the arbitrage which I had earlier mentioned;

·An overall leverage ratio will be used as a supplementary measure to the minimum risk-based framework. This is a limit to the leverage that became also infinite just before the crisis;

·There should be an element of anti-cyclical or dynamic provisioning, in the sense that the higher the risks, the higher the provisions or capital; and

·A global minimum liquidity standard for internationally active banks will be introduced.
All the rule changes look very sensible, but will they stop banks making more mistakes? I shall discuss this in the next article.

Datuk Seri Panglima Andrew Sheng is adjunct professor at Universiti Malaya, Kuala Lumpur, and Tsinghua University, Beijing. He has served in key positions at Bank Negara, the Hong Kong Monetary Authority and the Hong Kong Securities and Futures Commission, and is currently a member of Malaysia’s National Economic Advisory Council. He is the author of the book From Asian to Global Financial Crisis