Vitor Constâncio: Finance and regulation
Remarks by Mr Vitor Constâncio, Governor of the Bank of Portugal, at the European Association for
Banking and Financial History, Lisbon, 26 May 2006.
* * *
It is indeed a pleasure to participate in this panel at the beginning of a Conference that introduces an
historical perspective on the important subject of the relationship between the State and Financial
Services. History helps us to put into perspective the successive waves of regulation and deregulation
that have marked that delicate relationship. Financial activity, and banking activity in particular, has
been subject to different types of regulation since the banking crises of previous centuries convinced
authorities of that need. In general, finance is a process that produces and exchanges stores of value
in order to facilitate intertemporal decisions of saving and investment. Normally, finance implies giving
up liquidity in the present for the promise of future returns. So, it's an activity that is intrinsically
burdened with uncertainty as it implies trust and expectations about the future. It is also an activity
essential for economic life as it opens new opportunities for society to invest and increase productivity.
As it grew in complexity the systemic risk involved introduces an element of public good
considerations. It is therefore understandable that it became an activity subject to public regulation,
monitoring and supervision. The rationale for regulation rests on two types of justifications: first, the
important externalities associated with the systemic role of the financial sector and second, the nature
of an activity where asymmetries of information create the possibility of some market failures [see
Llewellyn (1999) for a good analysis of the issues]1
History shows that regulation and supervision of the financial sector evolved in response to crisis or
major episodes of turbulence. Robert Gordon (2005) has shown for instance in a recent paper2 that
one of the differences between the 20's and the 90's that help to explain why financial crises had
milder consequences in the latest decade is the existence of stronger regulation and supervision
(capital requirements, deposit insurance etc). In fact, one of the features of the more recent decades
has been a remarkable decrease in volatility of the real economy in spite of some episodes like the
97/98 Far East and Russian crisis and the demise in 2000 of the previous exuberant boom. These
shocks seem to contradict the theory that it was the reduction of shocks that explain the noted reduced
volatility of recent decades. More likely explanations are to be found in the flurry of financial
innovations that generalized risk-based pricing and the supply of many new credit instruments that
helped to finance economic activity even in unfavourable times. A second set of reasons includes
better public policies, from improved supervision to monetary policy. Monetary policy in particular has
been successful in providing an environment of stability and its enhanced focus on transparency and
in anchoring expectations has helped to reduce risk premiums. This more flattering view of the
contribution of monetary authorities does not preclude the controversies surrounding the relationship
between monetary and financial stability, a subject I will address later.
In spite of the positive effects of modern finance in contributing to the development and stability of
economic activity there is an increasing concern with financial stability as an objective of policy.
Practically all major Central Banks now publish special Reports on Financial Stability making clear that
they see it as something that falls within there sphere of competence. There is some ambiguity about
the definition of financial stability but two main meanings stand out. One, more fundamental, follows
Mishkin (1991)3 and defines financial stability as a situation where the financial system is able to
ensure in a lasting way, and without major disruptions, an efficient allocation of savings to investment
opportunities. In another sense, financial stability refers to absence of a major misalignment of asset
prices that can threaten future disruption of markets and the real economy. Both meanings are of
course connected as they point to the same notion of smooth function of financial institutions and
markets.
To justify the recent concerns with financial stability we can list both short term reasons and some
more structural factors. The first ones are the so-called global imbalances and the risks associated
with a possible reversal of asset price developments in various markets that may create turbulence
detrimental to the real economy. The first issue has been much discussed but despite the possibility of
a disrupted correction there are still reasons to hope that the winding down of both situations can
happen in a gradual and orderly manner.
There are nevertheless more structural reasons for the preoccupation of supervisors and monetary
authorities with financial stability. These are related with the new developments and structural changes
in the financial sector that generate new causes of concern and possibly justify new regulation or
increased monitoring.
Four aspects are particularly relevant from this perspective:
1. There has been a significant expansion of the financial sector in the past decades well above
the growth rate of the real economy. The financial sector became more important and more
complex and ensuring its stability became consequently more essential.
2. The sector changed in the direction of being more market-based with a reduced role for
traditional relationship banking. Technological developments in ITC, the greater availability of
information, the standardization of financial contracts, all contributed to a sort a
'commodification' of financial transactions. This has implied that monetary institutions and
monetary aggregates have lost weight in the total of financial assets, meaning that leverage
over the monetary base has increased continuously. Also, it is important to underline that
this expansion was accompanied by a greater share of a non-regulated segment including
hedge funds, private equity institutions etc.
3. Financial innovation produced new products and tailored new securities to particular needs
in terms of maturity, risk and liquidity. The complexity of derivatives and structured products
grows all the time as well as the size of derivatives markets. The more recent example is of
course the phenomenal growth of the market for credit derivatives. Credit Default Swaps
(CDS), Collateralized Debt Obligations (CDO), Credit-linked notes, credit spread options and
other products developed into a market that represents now more than 16 trillion euros and
is bigger than the total stock of existing corporate bonds and loans. These instruments fulfil
useful functions by allowing the transfer of risk, isolating and pricing pure credit risk,
providing liquidity to individual credits in times of stress and improving the management of
risk for various institutions etc. They create at the same time new sources of risk due to their
complexity, the uncertainty of mark-to-model valuations not tested in times of trouble
specially when secondary markets are not very liquid in general.
4. The fourth aspect deserving mentioning refers to the growing interdependence of markets
across types of products, across institutions and across borders. The more market-based
financial system continues to depend from monetary institutions for the provision of liquidity
and credit lines. Markets for different types of assets tend to depend from common factors
and show co-movement of returns. This greater interconnectedness is an element that
creates the so-called 'endogenous' component of risk, i.e. system-wide risk that is created by
the financial sector itself as the result of market participants' collective behaviour and its
effects on the main sources of risk. The increased concentration of institutions in various
markets also adds to the effects of this 'endogenous' risk
The main drivers of these structural changes were of course technological progress and the
movements of liberalization and globalization. The regulation system has responded to these changes
and evolved as turbulent episodes were occurring. Following the crisis of 97/98 there was a general
enhancement of regulation and supervision of the financial sector. New International Codes and
Standards were developed by the BIS, the IMF, IOSCO and IAIS. The preparation of a new Capital
Accord was initiated and its recent approval will change the standard for capital requirements in a
direction more sensitive to risk than the previous Basel I framework. In Europe, the mandatory
implementation of new International Accounting Standards introduced changes, not always welcomed,
in the reporting of financial institutions with consequences for prudential aspects. Another important
development has been the improved sophistication of a macro-prudential function developed by
Central Banks, Supervisors and International Institutions to analyse and monitor all the major risks at
the level of the system as a whole. The use of models of the financial sector allows the simulation of
various shocks to conduct stress tests at that level.
Despite all these improvements the question remains if some further changes are required in
regulation and supervision of the system in view of the new problems and risks created by the recent
structural changes. Before venturing an opinion let me stress again the positive aspects, including for
stability, that stem from those changes.
One general consideration was well described by Alan Greenspan (1999): "Multiple alternatives to
transform an economy's savings into capital investment act as backup facilities should the primary
form of intermediation fail."4 This substitution between different segments of the financial system help
to smooth overall financial flows which contributes to lower volatility in the real economy. Some
empirical and theoretical evidence has been accumulated that documents that feature of the financial
architecture [see Peres Jorge (2005)]5
In the same direction of contributing to the efficiency and stability of the system goes the diversification
of instruments that open new opportunities to finance different types of activity subject to diverse
contingencies in different phases of the cycle. This adds to the effectiveness of the system to foster
growth.
Finally, it is worth stressing that the new features of the financial system imply a significant progress in
the management of risk. The instruments of risk transfer allowed the entry of new players in the
market that enhances the absorption of credit risk although it remains difficult to assess where the risk
will end up in case of a general situation of stress.
This last point is just a first element of a series of new problems that we face as a result of those
structural changes experienced by the system. That particular one is specially related to the credit
derivatives market. This new market has been the source of uneasiness due the possibility of
operational risk and liquidity problems. Even the positive aspect of risk diversification that is fostered
by markets for Asset Based Securities and Collateralized Debt Obligations should not be
misinterpreted as, for instance, the existence of 'first loss' tranches that stay as responsibilities of the
originator banks cannot be ignored. Those practices imply that banks keep the riskier part of the
securitised portfolio and it should also be remembered that the transfer of risk allows the banks to take
other risks that they feel they have some advantage in managing. It is then not clear if the end result
means a reduction of risk for the banking system as a whole.
Another cause of concern is related with the increased 'endogenous risk' already mentioned and that
is very difficult to measure and to monitor, as Malcolm Knight (2004)6 has stressed. An additional point
refers to the fact that improvements in the managing of risk have made possible the assumption of
new risks sometimes difficult to evaluate. The appearance and expansion of a segment of
nonregulated institutions, hedge funds in particular, that have been responsible for the significant increase
of financial activity has been other source of some unease.
A last point worth mentioning has been an increase of the usual pro-cyclicality of the financial system.
This is a consequence of some of the structural changes already mentioned, but some regulatory
changes may have also contributed to exacerbate that tendency. Basel II, in spite of some
adjustments attempting to mitigate this effect, has been mentioned in this connection as the closer
association of regulatory capital to risk assessment will tend ceateris paribus to reduce capital
requirements in boom periods as ratings improve, the opposite being the case in periods of economic
slowdown. Another contributor to this pro-cyclicality may have been the introduction of the
International Accounting Standards that generalises the use of fair value accounting. The generalized
use of mark-to-market or mark-to-model of assets and liabilities increases the volatility of the accounts
of financial institutions. The important point though is the effect that this may have on market prices
themselves. As stressed in a recent paper by Plantin, Sabra and Shin (2005):7 "...marking to market
tends to amplify the movements in asset prices relative to their fundamental values in bad states of the
world.... Under the historical cost regime, actions of the firms are strategic substitutes. Sales by the
other firms drive the market price down, which makes holding the asset booked at the acquisition cost
more desirable. Conversely, in the mark-to-market regime, firm's actions are strategic complements.
The expectation of sales by the other firms makes holding the asset less desirable because of an
expected low market value at the reporting date. Strategic substitutability has a stabilizing effect, so
that the market price is artificially smooth as compared to the true value of the asset under the
historical cost measurement regime. Strategic complementarity adds endogenous volatility, so that the
market prices are artificially volatile as compared to the fundamental values in a marked-to-market
economy".
All the aspects I have been enumerating contribute, among other things, to increase volatility in asset
prices and possible episodes of significant misalignment. This prospect is certainly a cause of
uneasiness for monetary and financial authorities.
From this standpoint it is interesting to examine two views that seek to identify general factors behind
the tendency for asset price volatility. The first approach has been developed in the BIS research, in
particular by Claudio Borio and Philip Lowe (2002)8. The main idea is that under present
circumstances monetary stability is not enough by itself to ensure financial stability and may even
contribute to unstable prices of financial assets. This contradiction would stem from the very success
of monetary authorities in guaranteeing price stability in a credible way. The coexistence of an
environment of low interest rates with future inflation expectations well anchored in the low levels
defined by central banks objectives, would allow credit expansion that would fuel asset prices
increases. If valid, this view would be very disquieting to central bankers because the traditional view
has been exactly the opposite, i.e., that stability of prices of goods and services would stimulate
market participants to concentrate on the real factors that affect the fundamentals of valuation of
financial assets thus contributing to low volatility in their respective markets. This view, which is
certainly basically valid from a long term perspective, is nevertheless not incompatible with the
possibility that a short term trade-off may exist between monetary and financial stability. That may be
the case in particular in periods of transition after a long period of disinflation or when monetary policy
starts to change the interest rate cycle after a long period of low rates. Central Banks do not ignore
this possibility and take into consideration financial stability issues for which they feel responsible
which explains why they usually embark into interest rate smoothing and manage turning points of
policy at a measured pace.
It should be stressed that the existence of that short-term trade-off may create significant problems to
the inflation targeting monetary policy regime that is widely used nowadays. Being by definition very
much attached to targets and forecasts for inflation as an almost exclusive basis for decisions, that
framework has difficulty in incorporating other considerations into the decision-making process without
loosing some credibility. The notion that this could be overcome by extending the horizon of the
inflation forecast by a number of years does not look realistic and has not been attempted.
Turning to empirical considerations it is difficult reach a conclusion on the relevance of this view about
the short-term trade-off between monetary and financial stability for the behaviour of asset prices in
the recent past. On the other hand, the theoretical debate about the need of integrating or not asset
prices objectives in monetary policy strategies is also still going on and I will not try to address it here9.
Let me just state that "it is possible that monetary policy suffers from an endemic asymmetry, being
efficient to deal with the aftermath of financial crisis, but unsafe or ineffective to fight asset inflation.
Nevertheless, the more traditional asymmetry attributed to monetary policy, the one that considers it to
be more successful to control inflation than recessions, was never an obstacle to its use for both
purposes. In the same vein, one could argue that even without defining precise targets, interest rate
policy, in certain circumstances, should "lean against the wind" when it blows too strongly in asset
markets. In any case, the elusive search for anchors that could help to achieve both monetary and
financial stability will continue, and monetary policy cannot ignore the problem." (Constancio, 2002)10
The second broad view trying to provide a general explanation for the recent instability of asset price
has been put forward by Raghuram Rajan (2005),11 the IMF chief economist, in a recent noted paper.
What came to be known as the "Rajan risk" is linked with the structure of incentives of managers and
institutions in the new financial environment. The gain of importance of market-based non-regulated
institutions and the reduced weight of traditional banking, gives prominence to compensation schemes
more linked to returns which induces managers to incur into riskier transactions. Second,
performances in these growing sector of "investment institutions" tends to be measured essentially
against peers which fosters the herd behaviour already present in financial markets.
Both types of behaviour increase the probability of episodes of asset prices misalignments. The
system tends to assume more risks, including the so-called tail risk where probabilities are low but
losses can be high. Who would have thought some years ago that pensions funds and insurance
companies would become participants in the market for risk of default of other firms? On the other
hand, hedge funds manage nowadays five times more assets than in 1998 and are involved in less
liquid markets. Also their returns have become more correlated across supposed different types of
funds which seems to indicate that they could be subject to the same type of risks in a period of tighter
credit and stressful equity markets.
From all this the question that emerges is to determine if some new regulations are necessary or could
be helpful at this stage. We should always be cautious about introducing new regulations and an
evaluation of their costs must always be considered against their possible merits. Also, a thorough
dialogue with the sector has to be conducted to determine what can really work in practice and is
compatible with the incentives of institutions to comply with the rules. Also, the alternative route of
relying in more disclosure of information by the institutions themselves and of creating the conditions
for better market discipline should always be considered. This could be, for instance, the approach to
adopt in the case of hedge funds as there seems to exist internationally great reluctance in introducing
regulation and supervision in that segment. The arguments for that are based on the idea that public
policies are not justified to protect sophisticated investors, but that tends to forget the system-wide role
that those institutions now play with possible systemic consequences.
More generally, Rajan makes the proposal that market institutions should be encouraged to impose
the practice of requiring managers to have some of their own wealth invested for several years in the
funds they manage. Nevertheless, he mentions immediately that: "This is clearly, again, no panacea -
the managers of LTCM did have substantial stakes in their enterprise..."
The idea put forward by Charles Goodhart (2005)12 that capital requirements should be indexed to
developments of asset prices (e.g. regulatory capital for housing credit would increase as property
prices rises) is interesting but would also be of limited effect and would apply only to supervised
banks.
If the idea of imposing mandatory disclosure of more information by the new non-regulated institutions
is not followed, authorities will have to rely on enhanced market discipline through the indirect route of
putting more pressure on the supervised entities that provide liquidity and credit lines to the new
'investment institutions'. So, as always, we will have to wait for the system to be tested in order to see
if regulations will have to be adjusted again to the new financial structures.
Let me finalize with some remarks let me address the issue of the role that Central Banks should have
in relation to financial stability, even when they don't have the responsibility for supervision. In the first
place, they should improve what they already do in the field of macro-prudential analysis. Besides
publishing Financial Stability Reports, the authorities normally conduct top-down stress tests to assess
the resilience of the system to various shocks. In this context, new progress has to be made to
improve the methodologies to model the financial sector and its interaction with the economy. Also,
more international cooperation in this field of macro-prudential activities would be most welcomed.
Second, in conducting monetary policy they should not loose sight of financial stability issues,
specially in what regards turning points in managing the interest rate cycle and, in general, by
considering from a long term perspective what may be the effects of possible financial instability on
price stability, which is of course their main mission.
Finally, Central Banks should participate actively with their research departments in the efforts to
understand better the way modern finance operates and may create risks for the economy, with
particular emphasis on modelling the feedback effects that occurs between the real economy and the
financial sector behaviour. Understanding is certainly a necessary first step to avoid mistakes and
overcome the difficulties that monetary and financial authorities encounter in fulfilling their mission. As
a great scientist once said: "To be able to formulate the questions is to answer them". One could only
wish that the same would also be true about solving them in real life....