Rakesh Mohan: Emerging contours of financial regulation - challenges
and dynamics
Paper by Dr Rakesh Mohan, Deputy Governor of the Reserve Bank of India, for the Financial
Stability Review of Bank of France, 10 June 2009.
The assistance of Anand Sinha, Prashant Saran, P R Ravi Mohan, T Gopinath, and Muneesh Kapur in
preparation of the paper is gratefully acknowledged. The paper has also benefited from the Report of the Working
Group I of the G-20 on "Enhancing Sound Regulation and Strengthening Transparency".
* * *
The world is currently in the midst of the most severe financial and economic crisis since the
Great Depression. Although the crisis originated in the sub-prime mortgage market in the
United States, it then spread to Europe and later to the rest of the world. The speed of the
contagion that spread across the world is perhaps unprecedented. What started off as a
relatively limited crisis in the US housing mortgage sector turned successively into a
widespread banking crisis in the United States and Europe, the breakdown of both domestic
and international financial markets, and then later into a full blown global economic crisis.
Almost all governments and central banks of the world have been busy over the last 9-18
months in an effort to contain the effects of the crisis through both fiscal and monetary policy
measures, respectively. Just as the global nature of the crisis is unprecedented, so is the
global nature of the response, as exemplified by the coordinated action being committed to
by the G-20.
Along with the coordinated fiscal and monetary policy actions, a comprehensive
reexamination of the financial regulatory and supervisory framework is also underway around
the world.
Against this backdrop, this paper attempts to analyse the emerging contours of regulation of
financial institutions with an emphasis on the emerging challenges and dynamics. The paper
is organised as follows: Section I provides a broad overview of the global developments
which contributed to the current global financial crisis. Section II presents the ongoing
discussion and debate at the international level in the light of the shortcomings of the extant
regulatory framework. Section III analyses proposals for reforming the regulatory framework,
while Section IV discusses the difficulties in implementing the regulatory proposals.
I. Evolution of crisis: what went wrong?
What are some of the identifiable sources of market failures that led to the current financial
turbulence?
The current ongoing financial crisis is attributed to a variety of factors such as the
developments in the sub-prime mortgage sector, excessive leverage, lax financial regulation
and supervision, and global macroeconomic imbalances. At a fundamental level, however,
the crisis also reflects the effects of long periods of excessively loose monetary policy in the
major advanced economies during the early part of this decade.
After the dotcom bubble burst in the US around the turn of the decade, monetary policy in the
US and then in other advanced economies was eased relatively aggressively. Policy rates in
the US reached one per cent in 2002, and were held around these levels for an extended
period, longer than was probably necessary (Taylor, 2009; Yellen, 2009). Excessively loose
monetary policy led to excess liquidity and consequent low interest rates worldwide; and the
burst of financial innovation during this period amplified and accelerated the consequences
of excess liquidity and rapid credit expansion (de Larosière Report, 2009).
What is interesting about this episode is that, despite the persistent accommodative
monetary policy, the accompanying strong worldwide macroeconomic growth did not result in
measured inflationary pressures in goods and most services. Consequently, central banks in
advanced economies, particularly in the US, did not withdraw monetary accommodation for
an extended period. The excess liquidity worldwide did show up in rising asset prices, and
later in commodity prices, particularly oil. It was only then that measured inflation did start
rising and central banks began to tighten monetary policy, though belatedly.
With significant increases in both investment and consumption, along with declining
savings,1 aggregate demand exceeded domestic output in the US for an extended period,
leading to persistent and increasing current account deficits, as the domestic savings
investment imbalance grew. This large excess demand of the US was supplied by the rest of
the world, especially China, which provided goods and services at relatively low cost, leading
to corresponding current account surpluses in China and elsewhere. The surpluses
generated by the oil exporting countries added to the emerging global imbalances.
Large current account surpluses in China and other EMEs and equivalent deficits in the US
and elsewhere are often attributed to the exchange rate policies in China, other EMEs and oil
exporters. Given the fact that the US demand exceeded output, it is apparent that the US
current deficit would have continued at its elevated levels. In the event of a more flexible
exchange rate policy in China, the sources of imports for the US would have been some
countries other than China. Although the lack of exchange rate flexibility in the Asian EMEs
and oil exporters did contribute to the emergence of global imbalances, it can not fully
explain the large and growing current account deficits in the US, particularly since Europe as
a whole did not exhibit current account deficits at the same time.
Accommodative monetary policy and the corresponding existence of low interest rates for an
extended period encouraged the active search for higher yields by a host of market
participants. Thus capital flows to Emerging Market Economies (EMEs) surged in search of
higher yields, but could not be absorbed by these economies in the presence of either large
current account surpluses or only small deficits, largely ending up as official reserves. These
reserves were recycled into US government securities and those of the government
sponsored mortgage entities such as Fannie Mae and Freddie Mac. Thus, while
accommodative monetary policy kept short term interest rates low, the recycled reserves
contributed to the lowering of long term interest rates in the advanced economies, particularly
the United States. Such low long term interest rates contributed to the growth of mortgage
finance and consequent rising housing prices.
Furthermore, the stable macroeconomic environment - relatively stable growth and low
inflation - in the major advanced economies in the run up to the crisis led to sustained
underpricing of risks and hence excessive risk taking and financial innovation. It may be ironic that
the perceived success of central banks and increased credibility of monetary policy, giving
rise to enhanced expectations with regard to stability in both inflation and interest rates, could
have led to the mispricing of risk and hence enhanced risk taking. Easy monetary policy itself
may have generated a search for yields that resulted in a dilution of standards in assessing
credit risk leading to erosion of sound practices (Mohan, 2007). Lower yields encouraged
excessive leverage as banks and financial institutions attempted to maintain their profitability.
Lacunae in financial regulation and supervision allowed this excessive leverage in the
financial system. Assets were either taken off banks' balance sheets to off-balance sheet
vehicles that were effectively unregulated; or financial innovation synthetically reduced the
perceived risks on balance sheets.
The sustained rise in asset prices, particularly house prices, on the back of excessively
accommodative monetary policy, and lax lending standards coupled with financial
innovations, resulted in the high growth in mortgage credit to households, particularly to low
credit quality households. Due to the "originate and distribute" model, most of these
mortgages were securitized. In combination with strong growth in complex credit derivatives
and with the use of credit ratings, the mortgages, inherently sub-prime, were bundled into a
variety of tranches, including AAA tranches, and sold to a range of financial investors looking
for higher yields.
As inflation started creeping up beginning in 2004, the US Federal Reserve did start to
withdraw monetary accommodation. Consequently, mortgage payments started rising, while
housing prices started to ease. Low/negligible margin financing incentivised default by the
sub-prime borrowers. Although the loans were supposedly securitized and sold to the off
balance sheet special institutional vehicles (SIVs), the losses were ultimately borne by the
banks and financial institutions wiping off a significant fraction of their capital. The uncertainty
about the extent of the likely bank losses led to a breakdown of trust among banks. Given the
growing financial globalization, banks and financial institutions in other major advanced
economies, especially Europe, have also been adversely affected by losses and capital
write-offs. Inter-bank money markets nearly froze and this was reflected in very high spreads
in money markets and debt markets. There was aggressive search for safety, which has
been mirrored in very low yields on Treasury bills and bonds. These developments were
significantly accentuated following the failure of Lehman Brothers in September 2008 and
there was a complete loss of confidence.
The deep and lingering crisis in global financial markets, the extreme level of risk aversion,
the mounting losses of banks and financial institutions, the elevated level of commodity and
oil prices (until the third quarter of 2008), and the sharp correction in a range of asset prices,
all combined, have suddenly led to the sharp slowdown in growth momentum in the major
advanced economies, especially since the Lehman failure. Global growth for 2009, which
was seen at a healthy 3.8 per cent in April 2008, is now expected by the IMF to contract by
1.3 per cent.
Thus, the causes for the current crisis reflect the interaction of monetary policy, the choice of
exchange rate regime in a number of countries and important changes within the financial
system itself (de Larosière Report, 2009; BIS, 2008), along with lax regulation arising from
the belief in efficient markets and light touch regulation. To recap, low interest rates, together
with increasing and excessive optimism about the future pushed up asset prices, from stock
prices to housing prices. Low interest rates and limited volatility prompted the search for yield
down the credit quality curve, and underestimation of risks led to creation and purchase of
riskier assets. Central banks, focused on measured consumer price inflation and aggregate
activity, while neglecting asset price movements, did not perceive the full implications of the
growing risks until it was too late (IMF, 2009).
II. Shortcomings in financial regulation and supervision
There have been calls for fundamental rethinking on macro-economic, monetary and
financial sector policies to meet the new challenges and realities, which perhaps represent a
structural shift in the international financial architecture demanding potentially enhanced
degree of coordination among monetary authorities and regulators. A review of the policies
relating to financial regulation, in a way, needs to address both the acute policy dilemmas in
the short run and a fundamental re-think on broader frameworks of financial and economic
policies over the medium-term (Reddy, 2008).
A great deal of very active discussion is now going on internationally on the existing
regulatory practices and the future of financial regulation and supervision. It is also perhaps
correct to say that there is an emerging consensus on the directions that need to be taken on
financial regulation and supervision. Among the most influential reports on this issue are:
•
Report of the High Level Group on Financial Supervision in the European Union
(Chairman: Jacques de Larosière).
•
The structure of Financial Supervision: Approaches and Challenges in a Global
Market Place (Group of Thirty; Chairman: Paul Volcker).
•
The Fundamental Principles of Financial Regulation (The Geneva Report).
•
The Turner Review: A Regulatory Response to the Global Banking Crisis (Financial
Services Authority of the UK); and finally,
•
The Report of Working Group I of the G-20 on "Enhancing, Sound Regulation and
Strengthening Transparency (G-20).
What is common among all these reports is the acknowledgement that regulation and
supervision in the advanced economies was clearly too lax in recent times and that there
needs to be considerable rethinking leading to much strengthened, and perhaps, intrusive
regulation and supervision in the financial sector. There is clear recognition of serious
regulatory and supervisory failures.
The root of such re-thinking is really the questioning of the existing intellectual assumptions
with respect to the functioning of markets, and the nature of financial risk. To quote the
Turner Review:
"At the core of these assumptions has been the theory of efficient and rational markets. Five
propositions with implications for regulatory approach have followed:
(i) Market prices are good indicators of rationally evaluated economic value.
(ii) The development of securitized credit, since based on the creation of new and more
liquid markets, has improved both allocative efficiency and financial stability.
(iii) The risk characteristics of financial markets can be inferred from mathematical
analysis, delivering robust quantitative measures of trading risk.
(iv) Market discipline can be used as an effective tool in constraining harmful risk taking.
(v) Financial innovation can be assumed to be beneficial since market competition
would winnow out any innovations which did not deliver value added.
Each of these assumptions is now subject to extensive challenge on both theoretical and
empirical grounds, with potential implications for the appropriate design of regulation and for
the role of regulatory authorities". (Turner Review, 2009, p.30)
What were the specific developments in the financial system that arose from these broadly
accepted intellectual assumptions that led to the ongoing global financial crisis?
Financial and banking crises have a long history, which is as old as the existence of the
financial sector itself. What is common among almost all crises is the build up of excessive
leverage in the system and the inevitable bursting of the financial bubble that results from
such leverage. What is interesting about the current crisis is that this excess leverage
occurred over a period when greater consensus had developed through the Basel process
on the need for and level of adequate capital required in banking institutions across all major
jurisdictions. Furthermore, sophisticated financial risk management capabilities were also
believed to have been developed within large financial institutions during this period of
unusually high rapid growth in both the magnitude and sophistication of the financial system.
With financial deregulation in key jurisdiction like the United States and the U.K., along with
most other countries, financial institutions also grew in complexity. Financial conglomerates
began to include all financial functions under one roof: banking, insurance, asset
management, proprietary trading, investment banking, broking, and the like. The
consequence has been inadequate appreciation and assessment of the emerging risks, both
within institutions and system wide. What were the factors that led to this emergence of
excessive system wide and institutional risk?
Among the notable developments of the last decade has been the unprecedented explosive
growth of securitized credit intermediation and associated derivatives (Yellen, 2009). The
assumption underlying this development was that this constituted a mechanism that took risk
off the balance sheets of banks, placing it with a diversified set of investors, and thereby
serving to reduce banking system risks. As late as April 2006, the IMF's Global Financial
Stability Report noted that this dispersion would help "mitigate and absorb shocks to the
financial system" with the result that "improved resilience may be seen in fewer bank failures
and more consistent credit provision" (as quoted in the Turner Report, p.42).
This assumption has already proved to be erroneous, although simple forms of securitisation
have existed for a long time. Among the key functions of banks is maturity transformation:
they intermediate shorter term liabilities to fund longer term assets in the non-financial sector.
Banks are typically highly leveraged and hence trust and confidence is crucial to their
functioning and stability. Traditionally, therefore, banks exercised sharp vigilance on the risk
elements of their assets, which were typically illiquid, in order to ensure constant rollover of
their shorter term funding liabilities. What securitization does is to turn illiquid assets into
liquid ones, which in theory then disperse risks from the banks' balance sheets and also
reduce their requirements of banking capital. With assets themselves seen as liquid short
term instruments, they began to be funded by ultra-short term liabilities, including even
overnight repos whose volume increased manifold in recent years. Systemic risk increased
because traded instruments are inherently more susceptible to price swings depending on
changes in market sentiment. Furthermore, liquidity risks in such markets were also not
understood adequately. It was assumed that these liquid markets would always exist, and
hence securitized assets were assumed to be inherently less risky than illiquid long term
credit assets.
Financial innovation arising from the search for yields compounded this problem as second
order derivatives proliferated and their valuation became increasingly dependent on model
valuation and credit ratings, rather than observable and transparent market valuation, and
hence inherently more opaque. Thus, when problems arose in these markets and prices
were not visible, valuation of the assets of banks and the shadow banking system became
unobservable. Consequently, trust and confidence evaporated and markets froze.
Compounding these problems was the emergence of the shadow banking system that took
off assets from the banks' balance sheets, thereby reducing the latter's capital requirements.
The complexity and magnitude of intra-financial sector transactions exploded over this past
decade, particularly over the past five years. Thus the financial sector increasingly served
itself, exhibiting high profits and growth, while doing relatively little for the non financial
sectors of the economy, which the financial sector exists to serve in principle. The debt of
financial companies increased to levels exceeding the GDP of leading economies. Thus, in
the process of taking risks off balance sheets through securitization, these risks returned to
the extended banking system itself and the original rationale for securitization got belied.
Rather than reducing systemic risk the system of complex securitisaiton and associated
derivatives only served to increase systemic risk. Moreover, it became increasingly difficult to
trace where the risk ultimately lay.
The regulatory system was clearly behind the curve in taking account of these developments.
The procedures for calculating risk-based capital requirements under-estimated the risks
inherent in traded securitized instruments, thereby adding to the incentive for banks to
securitise assets into traded instruments, which bore lower risks weights. The trading of
these instruments has largely been in OTC markets that exhibit little transparency. As a
result of this overall process, banks became effectively under capitalized, and the leverage
ratios of the unregulated shadow banking system and investment banks reached
unsustainable levels.
With the existence of low interest rates, mispriced low risk perceptions, and inherent
incentives to originate lending and distribute securitized instruments, household
indebtedness increased to unprecedented levels, particularly for housing. Demand for
housing assets rose and hence housing prices. Thus micro behavior led to increased
systemic risk that was not adequately appreciated or understood, and hence not monitored
by the authorities.
Thus there are immense emerging challenges that confront financial sector regulators as a
consequence of the ongoing global financial crisis.
We can look forward to extensive debate at both the academic level and among
practitioners. How will we change our view on the efficiency and rationality of markets,
particularly financial markets? What will be the effect of such re-examination on financial
innovation in the future? What will regulatory authorities do in the meantime while these
debates are settled at the intellectual level? Will they overreact and restrict financial growth in
the months and years to come? Will this affect global GDP growth as well?
I now turn to the key proposals that are now being made for overhaul of the strong financial
regulatory architecture.
III. Reforming the regulatory framework: the future perspective
A great deal of discussion is going on at both the national and international levels on reform
of the financial regulatory system to address the various weaknesses that have emerged.
There is no question that financial regulation has to be strengthened all round. Hitherto
unregulated institutions, markets and instruments will now have to be brought under the
regulatory framework, and the framework itself will need to be redesigned to address the
emerging needs at both national and international levels. As this new enthusiasm for
financial regulation unfolds, it is important that we keep in mind the basic functions of the
financial system, and how they can be strengthened so that the needs of the real economy
are better served.
We need to ensure that the financial system continues to play a vital role in intermediating
savings for providing adequate levels of funding to the real sector, thereby supporting
economic growth. It needs to be recognized that financial markets will remain global and
interconnected, while financial innovation would continue to be important to foster economic
efficiency. Hence, while strengthening financial regulation and supervision, an endeavour
has to be made in this process to be careful not to stifle entrepreneurship and financial
innovation. But the following question needs to be constantly asked: "Financial innovation
towards what objective?" As long as financial innovation is seen to promote price discovery,
greater intermediation efficiency, and hence, overall efficiency and growth, it must be
encouraged, but with appropriate safeguards to maintain financial stability. Unproductive
financial innovation, however, will need to be discouraged. Moreover, the debate on financial
innovation and regulation has to be considered in terms of potential and systematic
relevance of such innovations besides the capabilities for bringing them effectively under the
regulatory umbrella (Mohan, 2007). Therefore, there is a need for reform of the regulatory
framework to shield the financial system from potential crises, while identifying measures to
mitigate the consequences of any future episodes of financial stress.
The regulatory framework will need to keep pace with the associated risks in a more rapid
and effective manner. Large complex financial institutions will continue to operate in multiple
jurisdictions in order to meet the needs of their large global clients, and supervision will need
to be better coordinated internationally with a robust global resolution framework. In order to
avoid regulatory arbitrage, there is a need for greater consistency in the regulation of similar
instruments and of institutions performing similar activities, both within and across borders.
In addition, capital markets will require greater emphasis on reducing counterparty risk and
on ensuring that their infrastructure allows them to remain a source of funding during periods
of stress. The post-crisis period is likely to be characterized by a financial system which
functions with lower levels of leverage, reduced funding mismatches (both in terms of
maturity and currency), less exposure to counterparty risk, and greater transparency
regarding financial instruments. After credit markets recover from the crisis, it will be
important to mitigate the inevitable pressure to expand profits through increased risk-taking.
A more developed macro-prudential approach will be important in this context.
The type, size, and cross-border exposures of institutions and markets that will emerge from
this crisis are likely to be considerably different from before. As banks and financial
institutions consolidate, policy makers will have to adapt prudential regulation to varying
degrees of size and concentration. Similarly, competition policy will be important in ensuring
healthy competition. Financial institutions, markets and instruments will therefore continue to
evolve in ways that pose challenges for regulation, notwithstanding the retrenchment that is
currently underway. Financial institutions, policymakers, supervisors and regulators will all
need to become better equipped to manage the interconnectedness of markets, both
domestically and globally, the effects of innovation, and the potential for incentives to
become misaligned.
It will be necessary to consider the appropriate timing for changes in the regulatory
framework going forward. Recommendations should promote proportionate regulatory
reaction when needed, acknowledging the possible limits of the self-regulation approach in
some contexts. For example, while ultimately capital buffers for the system should be
enhanced during the economic expansion in order to be drawn down as needed in
downturns, changes in the current environment may have negative consequences on the
real economy. A considered and comprehensive review of the consequences of reforms and
harmonization, coordinated across jurisdictions, is necessary to increase the effective
transition to a more stable financial system (G-20, 2009).
In short, the overarching mandate of reforms is to make regulatory regimes more effective
over the cycle. This is related to many other issues including certain aspects of
compensation schemes at financial institutions, of margin requirements and risk
management practices focused on Value-at-Risk calculations based on short historical
samples, of the capital adequacy framework, and of valuation and loan-loss provisioning
practices. In addition, there is a need to redefine the scope of the regulatory framework in
order to establish appropriate oversight for the institutions and markets that may be the
source of systemic risk. Risk management also needs to be enhanced to better evaluate
vulnerabilities arising from low-frequency, system-wide risks, and to better mitigate these
risks.
Against this broad background, this section endeavours to focus on defining the priorities for
action in so far as financial regulation and supervision are concerned.
Macro prudential orientation
As observed, the build up of micro institutional risks has resulted in the unfolding of massive
macro risk, partly through the rise in unsustainable asset prices. As a supplement to sound
micro-prudential and market integrity regulation, national financial regulatory frameworks
therefore should be reinforced with a macro-prudential oversight that promotes a
systemwide approach to financial regulation and supervision and mitigates the build-up of
observable excess risks across the system. Prudential regimes should encourage behaviour
that supports systemic stability; discourages regulatory arbitrage; and adopts the concept of
"systemic" risk, factoring in the effects of leverage and funding. In most jurisdictions, this will
require improved coordination mechanisms between various financial authorities, mandates
for all financial authorities to take account of financial system stability, and effective tools to
address systemic risks. It will also require an effective global table, which is now proposed to
be the Financial Stability Board, to bring together national financial authorities to jointly
assess systemic risks across the global financial system and coordinate policy responses.
A number of policy institutions, particularly central banks, have enhanced their analysis of
systemic risks in recent years - many of the systemic vulnerabilities that caused or enhanced
the current turmoil had in fact been identified - but policy mechanisms to effectively translate
these analyses into policy action have been lacking. The basic idea here is to multiply the
capital adequacy ratios with a systemic risk factor. Better measures of macro-prudential risk
are to be found. It is argued that leverage ratios, maturity mismatch and estimates of bank
credit expansion should be taken into account. Highly leveraged and fast growing "systemic"
institutions would be subject to higher capital requirements than the rest. The idea is that
when there is increasing systemic risk, with increasing leverage, maturity mismatch, credit
expansion and asset price increases during boom times, banking capital required should
increase, and reduce during a downturn when deleveraging takes place (Geneva Report,
2009).
Potential macroprudential tools that could be explored further could include:
•
Complementing risk-based capital measures with simpler indicators aimed to
measure the build-up of leverage, with enhanced sensitivity to off-balance sheet
exposures;
•
Capital requirements that adjust over the financial cycle;
•
Loan-loss provisioning standards that incorporate all available credit information;
• The use of longer historical samples to assess risk and margin requirements; and
•
Greater focus on loan-to-value ratios for mortgages.
Further, the challenge is to continually endeavour to strike a balance between macro and
micro prudential regulation.
Regulatory regime
With the emergence of the shadow banking system and other leveraged financial institutions,
the scope of regulation and oversight needs to be expanded to include all systemically
important institutions, markets and instruments. Accordingly, the perimeter of the financial
sector surveillance would have to be extended possibly with differentiated layers to allow
institutions to graduate from simple disclosures to higher levels of prudential oversight as
their contribution to systemic risks increases. Financial authorities will need enhanced
information on all material financial institutions and markets, including private pools of capital.
Large complex financial institutions require particularly robust oversight given their size and
global reach. Consideration would also need to be given to put in regulatory disincentives for
such institutions to not become too big to fail. The regulatory and oversight framework should
strive to treat similar institutions and activities consistently, with greater emphasis on
functions and activities and less emphasis on legal status.
The main bone of contention here, inter alia, is whether and how to regulate private pools of
capital, including hedge funds. There have been differences with regard to the role of these
funds in the current global financial crisis. Nevertheless, there is a broad agreement that
private pools of capital, including hedge funds, can be a source of risk owing to their
combined size in the market, their use of leverage and maturity mismatches, and their
connectedness with other parts of the financial system.
The widespread reliance of market participants on credit ratings of market instruments led to
inadequate risk analysis by themselves. Thus, credit rating agencies (CRAs) will have to be
subject to a regulatory oversight regime. Further, there is a need for modifications to a rating
agency's practices and procedures for managing conflicts of interest and for assuring the
transparency and quality of the rating process, particularly on the process underlying ratings
of complex securitised instruments and derivatives. Given the global scope of some credit
rating agencies, the oversight framework should be consistent across jurisdictions with
appropriate sharing of information between national authorities responsible for the oversight
of credit rating agencies.
Procyclicality
Once conditions in the financial system have recovered, international standards for capital
a