by Ingrid Goodspeed, Governor of the South African Institute of Financial Markets
Because of this law (…Wall Street Reform and Consumer Protection Act (Dodd Frank Act)…), the American people will never again be asked to foot the bill for Wall Street’s mistakes.
President Barack Obama, July 2010
But if there is one constant in financial regulation, it is that we seem to be singularly incapable of learning from our mistakes, because we keep doing the same thing. And the same thing keeps failing. If regulation failed, we are told, the answer is more regulation. And if the regulators failed, the answer is to give those same regulators even greater powers over the financial system.
Committee on Financial Services, U.S. House of Representatives, July 2014
In recent decades the global financial system has changed noticeably:
- The assets of the world’s banking system are concentrated in the hands of a few globally-active systemically-important institutions that are so large, complex, diversified and interconnected that regulators and policymakers would not dare let them fail in a crisis. During the 2007/08 financial crisis the fear that such financial institutions might fail resulted in governments providing them with extraordinary taxpayer-funded assistance.
- A large number of non-banks carrying out bank-like activities i.e., maturity, credit and liquidity transformation, exist outside the prudential supervision and capital requirements that apply to the traditional banking system. These so-called shadow-banks rely on potentially unstable forms of short-term funding and hold half (in the US) and a quarter (in the EU) of all credit market assets, which are generally longer-term. Yet they have no formal access to safety net mechanisms such as emergency liquidity funding or lender-of-last-resort facilities or deposit insurance.
- The asset management industry has grown rapidly with assets under management concentrated in the hands of the largest firms. Securities regulators generally focus more on investor protection than on the systemic risk of asset managers. Now regulators in major jurisdictions are increasing their oversight of asset managers including through stress testing.
- There are an increasing number of conglomerates operating across the financial sector in banking, securities, and insurance. Yet no single regulator is tasked with assessing the risks posed by such groups across the entire financial system.
- There is a growing prevalence of complex and poorly-disclosed investment products that transfer risk to retail investors, many of who are unable to manage or mitigate the risk. In addition the complexity and opacity of retail mortgage and other lending products has increased. In the US regulators failed to appropriately understand the risks that certain mortgage products posed to consumers and the stability of the financial system. In South Africa neither regulators of African Bank i.e., South African Reserve Bank and the National Credit Regulator fully understood the risk of its monoline business model nor anticipated its failure.
That the financial regulatory system has not kept up with these changes in the financial system became painfully clear in the run-up to the financial crisis when regulators and policymakers alike, especially in the developed world, came under significant strain. Limitations, gaps and weaknesses in the supervision and regulation of financial institutions became evident as did the inability of regulators to monitor, prevent, or address risks as they built up in the system. In addition home and host regulators operated in silos and no regulator was tasked with protecting the financial system as a whole.
An inevitable and predictable result of the financial crisis and the subsequent global reform agenda to restore financial stability and help build a financial system that serves the real economy and supports economic growth, is a substantive overhaul of the financial regulatory framework. When discussing the cost of such regulatory change there are generally two extreme views: (i) that regulatory change has been unprecedented, capricious, sometimes antithetic as well as unpredictable and fragmented in terms of timelines and has placed onerous demands on financial institutions, particularly smaller ones, at the expense of economic growth and (2) the burden of regulatory change is warranted to avoid another financial crisis and the costs thereof pale into insignificance next to the price of a crisis.
The objective of this article is to open discussions on the cost of regulation in the aftermath of the financial crisis and to identify possible sources of such costs for individual financial institutions and the financial system as a whole.
Global regulatory reform agenda
Several measures are being introduced to achieve the global reform objectives of (i) restoring financial stability while still supporting other policy objectives such as appropriate market conduct (and consumer protection) and market integrity and (ii) building a financial system that serves the real economy and supports economic growth.
Restoring financial stability while still supporting good market conduct and consumer protection
A substantial part of the reform agenda has focussed on reducing systemic risk across the financial system. These are highlighted in table 1:
Table 1: Reducing systemic risk across the financial system
|Financial market infrastructures||Improve the transparency and regulatory oversight of over-the-counter derivatives markets|
|Shadow banks||Ensure all market participants are appropriately regulated and subject to suitable prudential capital and liquidity requirements and supervisory oversight|
|Insurers||Introduce a revised prudential regulatory framework, known as Solvency II globally and Solvency Assessment and Management (SAM) in South Africa to secure their stability|
In addition measures are required to support the policy objective of good market conduct and improve the behaviour of financial institutions and ensure their fair treatment of consumers. Such initiatives should (i) ensure sound consumer redress by strengthening financial sector alternative dispute resolution mechanisms such as the ombuds system; (ii) enhance the independence and reliability of credit ratings and (iii) promote competitive markets to provide consumers with greater choice amongst financial products and place pressure on product providers to keep prices competitive and quality high.
Securities regulators should encourage open, transparent, competitive, and financially sound markets that protect market users and their funds, consumers, and the public from fraud, manipulation, and abusive practices related to derivatives and other products.
Build a financial sector that serves the real economy and supports economic growth
Across the world the financial system has increased both in absolute size and relative to the real economy characterised by easy credit, significantly increased leverage, interconnectedness, innovation and complexity as well as the trading of financial assets and commodities unrelated to any underlying productive activity and the domination of short term technical trading in the currency and currency derivative markets. This is known as the financialisation or financial deepening of the economy.
There does not appear to be a straight-forward causal relationship between the financialisation of an economy and the annual rate of economic growth, particularly in developed economies. It is generally accepted that strong and deep financial markets are required to promote economic growth by providing diversified and market-based intermediation between ultimate borrowers and investors. However there is a point at which financial deepening leads to financial excesses and becomes a drag on growth i.e., higher growth in the financial sector reduces real growth.
There are a number of possible policy responses to financial excesses:
- Regulation must keep pace with the complexity produced by financial innovation such as over-the-counter credit derivatives and structured finance
- Prudential regulators should restore simplicity by going back to basics and not rely solely on a ballooning number and sometimes-opaque risk statistics such as default probability, loss-given-default VaR without appropriate stress testing and common-sense judgement
- Securities regulators should maintain fair, orderly, and efficient markets that fulfil their primary function of capital formation i.e., being a source of finance for the real economy
- The regulatory and supervisory framework should be strengthened to reflect the lessons from the 2007/08 financial crisis. Banks should hold strong capital buffers over the cycle, especially when the economy is flush with liquidity and underwriting standards are relaxed to make credit more easily available. Additional measures in addition to Basel III minimum requirements could include maximum loan-to-value ratios, capital charges on structured investment vehicles, capital charges based on leverage ratio; stronger liquidity risk management frameworks and dynamic provisioning
- The macro-prudential framework, which focuses on the system as a whole, should encourage the build-up of capital cushions in good times so these can be unwound when the cycle turns and react to credit booms before they turn into financial excesses.
Cost of the global reform agenda
The costs of the reforms are generally considered to be private costs to financial institutions (and their shareholders and employees) that are offset by wider economic and societal benefits to stakeholders in society, including customers (e.g. depositors, borrowers and consumers of financial services), creditors, and taxpayers. However it may be that such private costs will be passed on to the customers of individual financial institutions.
Scale of the legislative response
Increased regulation was an inevitable result of the financial crisis. Table 2 attempts to indicate, albeit rudimentary, the scale of the legislative response post the 2007/08 financial crisis.
Table 2: Scale of the regulative response
|The Basel Accord of 1988 (Basel I) was seminal and the first international prudential regulatory agreement. Basel I was 30 pages long. However Basel I was not considered sufficiently risk sensitive. The Market Risk Amendment was agreed in 1996, which allowed banks to use internal risk models and was 63 pages long. A revised Basel Accord (Basel II) was agreed in 2004. It allowed and encouraged internal models to deliver lower capital charges. Basel II was 347 pages long.||Basel II was not yet fully implemented across the world when the financial crisis hit. Basel III was agreed in 2010. It attempts to ensure banks’ risk exposures are backed by a high quality capital base. Basel III was 616 pages long, almost double Basel II.|
|National legislation to implement Basel I required
National legislation to implement Basel II in South Africa required 274 pages of rules.
|National legislation to implement Basel III required
|In the US the legislative response to the Great Depression of the 1930s was the US Glass-Steagall Act 1933. The Act was 37 pages long.||In the US the legislative response to the financial crisis of 2007/08 was the Wall Street Reform and Consumer Protection Act of 2009 (Dodd-Frank Act) was 848 pages long.The Act requires 400 pieces of rules estimated at 30 000 pages.|
|Europe proposed and adopted pieces of law post the financial crisis
South Africa is also in the process of introducing a number of pieces of financial sector policy and law. These include:
- The Financial Sector Regulation Bill that sets up the twin peaks model of financial regulation
- The Market Conduct Policy Framework and proposed Conduct of Financial Institutions Bill
- The SAM framework that establishes a risk-based solvency regime for short- and long-term insurers
- The Treating Customers Fairly (TCF) regulatory framework
- Retirement reform proposals
- The Retail Distribution Review that ensures that advisory and intermediary services promote appropriate, affordable and fair advice and associated services to consumers;
- Binder Regulations that govern the way binder holders perform their functions as the agents of insurers to ensure the accountability of the insurers is retained, responsible outsourcing, policyholder protection and conflicts of interest are appropriately managed
- Hedge funds regulations that regulate and supervise certain hedge fund structures under the Collective Investment Scheme Control Act, 2002 (CISCA)
- Amendments to the National Credit Act (2005) and the introduction of regulations that specify, amongst others, affordability criteria for lending
- Demarcation regulations that specify the types of health insurance policies permissible under the Long-term Insurance Act.
Scale of people resources
The rise in the number of people required by the regulators is a predictable result of the increase in scale of the legislative response.
In 1980, there was one UK regulator for about 11 000 people employed in the UK financial sector. This increased to one regulator for every 300 people employed by 2011.
The trend is similar in the US. In 2009 there were 14000 regulators employed at federal regulatory bodies – Federal Deposit Insurance Corporation (FDIC), Board of Governors of the Federal Reserve (Fed) (bank supervision and regulation), Office of the Comptroller of the Currency (OCC) and Securities and Exchange Commission (SEC). This increased to 18 500 people (about 3 regulators per bank) in 2010. And these numbers do not include state supervisors of state-chartered banks.
Financial institutions also need to increase human resources, particularly compliance people, to deal with the increase in scale of the legislative response. For example JPMorgan Chase employs almost 1 000 people to ensure the group complies with the rules imposed in the aftermath of the financial crisis.
The world’s largest banks have paid substantial fines (see table 3) since 2008 for breaching a variety of financial regulations.
Table 3: Fines paid by the world’s largest banks
as at 31 Dec 2013
|Bank of America||39.09||27.31||66.40|
|JP Morgan Chase & Co||26.61||9.17||35.78|
|Lloyds Banking Group plc||8.91||3.82||12.72|
|Royal Bank of Scotland||3.54||4.92||8.47|
Source: LSE Conduct Costs Project 2012-2014 http://blogs.lse.ac.uk/conductcosts/
The fines continued after 2013. In May 2015 it was reported that six global banks will pay over USD5.6 billion to settle allegations that they rigged foreign exchange markets.
In South Africa the SARB imposed administrative sanctions of R125 million on the big four South Africa banks in April 2014 for failing to implement sufficient anti-money laundering controls.
Cost to the financial system
The costs of regulation that will be a problem are those that arise if the regulations hinder the ability of the financial system to fulfil its key economic functions of financial intermediation, payment services provision, risk transformation and insurance. For example if increased liquidity requirements and deleveraging can only be achieved at the cost of lending to the real economy.
Many financial institutions, particularly in the US and South Africa, are operating in regulatory structures that are cumbersome and costly, requiring multiple licences and subject to several at times competing regulators and policymakers that have different and at times conflicting objectives. This has led to fragmented supervision, regulatory arbitrage and at times delayed and weak enforcement.
In addition since part of the cost of regulatory compliance is fixed, it falls more heavily on smaller financial institutions. Because of their scale and the resources larger institutions are better able to absorb new regulatory burdens than smaller ones. This unequal regulatory burden eventually results in a less competitive financial sector as smaller institutions overcome by the volume and complexity of regulations are forced to exit or merge with other institutions. For example at the end of 2010 there were 7658 banks in the US. By the end of 2013, the number of banks had decreased by 11 per cent to 6 812 banks. As smaller banks exit the industry, the market power of larger banks becomes more entrenched as does their too-big-to-fail status.
To avoid legal complexity and fully harmonise regulatory and supervisory standards across the financial sector it is necessary for financial sector regulators and policymakers to work closely together to (i) remove regulatory gaps, overlaps, and conflicting policies (ii) allow appropriate and effective prudential and market-conduct supervision of all market participants (iii) consolidate and better allocate resources; (iv) put in place appropriately-represented governance structures and parliamentary oversight and (v) reduce opportunities for regulatory arbitrage and competition amongst regulators and (vi) evaluate the quality of a group’s business model, management, risk-taking behaviour, integrity and market conduct.
Implications for financial institutions
Financial institutions will need to respond to the sweep of regulatory change. There are a number of practical issues that institutions could consider:
Know your regulator
In South Africa a number of regulators, agencies and self-regulatory organisations share oversight of the financial system (see figure 1). Since a number of changes, in particular the introduction of the twin peaks regulatory framework, are envisaged to this regulatory structure it is important that institutions have a thorough understanding of which regulator will be regulating or supervising which part of their business.
Figure 1: Current South African financial regulatory structure
Know what is guiding your regulator
Financial institutions should also understand what policy is being developed by international standard setting bodies (see figure 2) for implementation in local jurisdictions.
Figure 2: International financial architecture – driving local implementation
Reassess risk management frameworks
Compliance functions need to ensure that their risk management frameworks remain appropriate and relevant. This will typically require the review of the risk appetite, risk governance structure, risk policies, processes and procedures, risk strategy and risk management process.
In addition institutions should review all compliance resources and skills to ensure they have the capacity and capability to successfully handle and implement new regulatory requirements.
A regulatory framework with clear law, objective criteria and broad principles, backed up by well-defined rules, is necessary to ensure a stable competitive financial system that protects consumers and ensures access to finance for consumers and small businesses. However changes to the regulatory framework should be implemented in a considered and planned way to avoid unintended consequences and unnecessary regulatory burdens, especially on smaller institutions.
And in the words of Andrew G Haldane: “Modern finance is complex, perhaps too complex. Regulation of modern finance is complex, almost certainly too complex. That configuration spells trouble. As you do not fight fire with fire, you do not fight complexity with complexity. Because complexity generates uncertainty, not risk, it requires a regulatory response grounded in simplicity, not complexity”.
Stephen G Cecchetti and Enisse Kharroubi. February 2015. Why does financial sector growth crowd out real economic growth? Accessed May 2015. http://www.bis.org/publ/work490.htm
European Commission. May 2014. Economic Review of the Financial Regulation Agenda. Accessed May 2015. http://ec.europa.eu/internal_market/finances/docs/general/20140515-erfra-working-document_en.pdf
Stanley Fischer. March 2015. The Importance of the Nonbank Financial Sector. Accessed May 2015. http://www.federalreserve.gov/newsevents/speech/fischer20150327a.htm
Ingrid Goodspeed. October 2011. Out of the shadows: an overview of the shadow banking system. Accessed May 2015. http://financialmarketsjournal.co.za/oldsite/14thedition/printedarticles/shadowbanking.htm
Andrew G Haldane. August 2012. The dog and the frisbee. Accessed May 2015. http://www.bankofengland.co.uk/publications/Pages/speeches/2012/596.aspx
Daniel K. Tarullo. January 2015. Advancing Macroprudential Policy Objectives. Accessed May 2015. http://www.federalreserve.gov/newsevents/speech/tarullo20150130a.htm
Volker Alliance. May 2015. Reshaping the financial regulatory system. Accessed May 2015. https://volckeralliance.org/resources/reshaping-financial-regulatory-system