Kaufman: The principles of sound regulation
By Henry Kaufman
Financial Times, August 5 2008.
Recent upheavals and downdraughts in financial markets have sent a loud and
clear message: revamp our system of financial regulation. But before we
begin drafting new rules or eliminating old ones, we need to reconsider
fundamental principles. At least eight precepts of sound financial
regulation should be considered.
First, we should recognise the deregulation illusion. When faced with the
choice between regulated and deregulated financial markets, most nations try
to sidestep. Market participants laud the virtues of unhindered competition
over regulation for disciplining market behaviour. That works, by and large,
for small and medium-sized companies, but not for the integrated financial
giants that dominate many aspects of financial markets. These behemoths are
³too big to fail². Whenever one of these favoured institutions gets into
serious trouble, some kind of formal or informal safety net is deployed.
A second and related precept is that comprehensive financial deregulation is
impractical as well as politically and socially intolerable. This precept
rests on the necessity that financial authorities safeguard the payments
mechanism. Indeed, most large depositors are also fiduciaries (investment
advisers, corporate treasurers and the like) that are compelled to shift
funds out of institutions that seem to be in peril. Given these realities,
the only way to abandon the ³too big to fail² doctrine is to ensure that
leading institutions are too strong to fail. That, in turn, requires close,
ongoing official scrutiny.
The more free-market oriented our economy, the greater its need for official
financial supervision. A truly market-oriented economy poses high risks of
business failure and, correspondingly, high risks to institutions that lend
to and invest in the private sector. Moreover we need to acknowledge that,
while financial competition fosters innovation, it also contributes to
instability. Consequently, official supervisors need to be more know
ledgeable about the diverse range of today¹s financial operations.
Third, a new regulatory regime should strive to encourage the highest
standards of business conduct. This has been difficult to achieve because of
increasing financial concentration. Financial institutions have found it
difficult to balance their private interests with their public
responsibilities. Nevertheless, large institutions perform indispensable
functions and the consequences of their failure extend beyond the loss of
private capital. For this reason, leading financial firms should be both too
big to fail and too good to fail.
Fourth, in formulating sound financial and regulatory supervision, market
participants will push risk-taking to the marginal edge unless constrained.
It is on the edge where competition is the least intense, where profit
possibilities (and losses) and fees are the highest and where ancillary
business opportunities are most abundant. When markets are highly
deregulated, firms face stiff competition and therefore have great incentive
to take risks at the marginal edge.
Fifth, regulation lags behind shifts in markets and technologies. Historical
examples are abundant, from the rise of asset-liability management and
negotiable certificates of deposit in the 1960s to syndicated credit in the
1970s to the derivatives explosion of the 1980s. In each case, it took
regulators decades to understand both the technical complexities and the
broader structural implications of these innovations.
Sixth, deregulation is making the job of the US Federal Reserve more
challenging. The less regulated a financial market, the harder it is for
central bankers to stabilise markets through monetary adjustments. The Fed
did not quickly understand the implications for monetary policy of the many
structural changes in our market: the new credit instruments, the new credit
techniques and quantitative risk analysis.
Seventh, a new system of financial regulation should pay less attention to
minor matters and more to broad, systemic weaknesses. Regulations that may
have made sense initially often become outmoded by the rapid pace of market
and technological change, yet tend to linger on the books. Still another
reason is the fragmented structure of regulation in the US. We regulate
banking and securities with overlapping agencies while leaving out insurance
at the federal level. Banks, but not securities firms, are regulated at the
holding company level. In too many cases, no agency is charged with looking
at the full picture.
Finally, in crafting new approaches to financial regulation we must
acknowledge the international dimension of leading institutions and markets,
and strive to harmonise accounting standards, disclosure and trading
practices across national boundaries. Even though all the main instruments
and participants in today¹s capital markets are transnational, standards and
practices vary considerably.
There are strong political deterrents against reform of financial
regulation. Quite a few of the overlapping official organisations will be
unwilling to cede power. Many large financial institutions will resist new
constraints on their autonomy. Assuming that much of the new and improved
structure of supervision and scrutiny will be the responsibility of the
Federal Reserve which, after all, is the ultimate guardian of our
financial markets the Fed itself will need to change its institutional
culture. Among other things, central bankers will need to make financial
supervision a much higher priority in their deliberations.
clear message: revamp our system of financial regulation. But before we
begin drafting new rules or eliminating old ones, we need to reconsider
fundamental principles. At least eight precepts of sound financial
regulation should be considered.
First, we should recognise the deregulation illusion. When faced with the
choice between regulated and deregulated financial markets, most nations try
to sidestep. Market participants laud the virtues of unhindered competition
over regulation for disciplining market behaviour. That works, by and large,
for small and medium-sized companies, but not for the integrated financial
giants that dominate many aspects of financial markets. These behemoths are
³too big to fail². Whenever one of these favoured institutions gets into
serious trouble, some kind of formal or informal safety net is deployed.
A second and related precept is that comprehensive financial deregulation is
impractical as well as politically and socially intolerable. This precept
rests on the necessity that financial authorities safeguard the payments
mechanism. Indeed, most large depositors are also fiduciaries (investment
advisers, corporate treasurers and the like) that are compelled to shift
funds out of institutions that seem to be in peril. Given these realities,
the only way to abandon the ³too big to fail² doctrine is to ensure that
leading institutions are too strong to fail. That, in turn, requires close,
ongoing official scrutiny.
The more free-market oriented our economy, the greater its need for official
financial supervision. A truly market-oriented economy poses high risks of
business failure and, correspondingly, high risks to institutions that lend
to and invest in the private sector. Moreover we need to acknowledge that,
while financial competition fosters innovation, it also contributes to
instability. Consequently, official supervisors need to be more know
ledgeable about the diverse range of today¹s financial operations.
Third, a new regulatory regime should strive to encourage the highest
standards of business conduct. This has been difficult to achieve because of
increasing financial concentration. Financial institutions have found it
difficult to balance their private interests with their public
responsibilities. Nevertheless, large institutions perform indispensable
functions and the consequences of their failure extend beyond the loss of
private capital. For this reason, leading financial firms should be both too
big to fail and too good to fail.
Fourth, in formulating sound financial and regulatory supervision, market
participants will push risk-taking to the marginal edge unless constrained.
It is on the edge where competition is the least intense, where profit
possibilities (and losses) and fees are the highest and where ancillary
business opportunities are most abundant. When markets are highly
deregulated, firms face stiff competition and therefore have great incentive
to take risks at the marginal edge.
Fifth, regulation lags behind shifts in markets and technologies. Historical
examples are abundant, from the rise of asset-liability management and
negotiable certificates of deposit in the 1960s to syndicated credit in the
1970s to the derivatives explosion of the 1980s. In each case, it took
regulators decades to understand both the technical complexities and the
broader structural implications of these innovations.
Sixth, deregulation is making the job of the US Federal Reserve more
challenging. The less regulated a financial market, the harder it is for
central bankers to stabilise markets through monetary adjustments. The Fed
did not quickly understand the implications for monetary policy of the many
structural changes in our market: the new credit instruments, the new credit
techniques and quantitative risk analysis.
Seventh, a new system of financial regulation should pay less attention to
minor matters and more to broad, systemic weaknesses. Regulations that may
have made sense initially often become outmoded by the rapid pace of market
and technological change, yet tend to linger on the books. Still another
reason is the fragmented structure of regulation in the US. We regulate
banking and securities with overlapping agencies while leaving out insurance
at the federal level. Banks, but not securities firms, are regulated at the
holding company level. In too many cases, no agency is charged with looking
at the full picture.
Finally, in crafting new approaches to financial regulation we must
acknowledge the international dimension of leading institutions and markets,
and strive to harmonise accounting standards, disclosure and trading
practices across national boundaries. Even though all the main instruments
and participants in today¹s capital markets are transnational, standards and
practices vary considerably.
There are strong political deterrents against reform of financial
regulation. Quite a few of the overlapping official organisations will be
unwilling to cede power. Many large financial institutions will resist new
constraints on their autonomy. Assuming that much of the new and improved
structure of supervision and scrutiny will be the responsibility of the
Federal Reserve which, after all, is the ultimate guardian of our
financial markets the Fed itself will need to change its institutional
culture. Among other things, central bankers will need to make financial
supervision a much higher priority in their deliberations.
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