As I was writing my new book on International Finance Regulation, the Quest for Financial Stability, published this week by in Wiley Financial Series, it became increasingly obvious that recent regulatory developments around the world were not converging to the same goal.
Global financial stability was not the main goal of new regulation. Yet, banks had been at the origin of the most severe international crisis, rather than the victims of macro economic imbalances. It was therefore critical to create a global framework that would neutralize, as much as possible, the risks that finance could once again become a source of instability by itself.
A web of domestic regulators
The current regulatory structure does not provide this framework since the regulatory efforts have mostly been developed by national regulators. The United States were the first to come with the Dodd-Frank Act, while Europe agreed on a succession of topical directives. At the same time Asia, considering that it was a transatlantic crisis that was not the result of any management or regulatory failures on their continent, stayed on the fence.
Basle III regulation is the only serious attempt to provide a global structure through ratios that would require adequate capitalization and enough liquidity while limiting the leverage of financial institutions. Yet, it will take time to implement and there are resistances in the US and in Europe to accept the rules as they are.
Europe is trying to create a framework for the Eurozone, and has launched a European Banking Union that intends to harmonize the regulation of banks and make the European Central Bank the supreme regulator of the 129 systemically important financial institutions of its Member States.
Complexity will inevitably result in conflicts of law and interpretations.
Central Banks and financial stability
The new paradigm of Central Banking has become so complex that it becomes the source of conflicts of interest. The quantitative easing policies have increased the balance sheet of central banks by $ 9 trillion, without these amounts being recognized as public debt. By pretending that they can be effective in boosting employment, they became politically too important to remain independent. It would be great if it were true. The fact is that these trillions went straight to banks and created a world of negative interest rates threatening pensions and savings.
Those ill-advised policies created an imbedded conflict of interest between their role as custodians of financial stability and regulators of the systemically important banks. It boosted banking profits without increasing investment.
Furthermore, the question of the size of their balance sheets could become a source of instability. None of them is capable to intervene should another banking crisis erupt.
The mindset has not changed
As banks continue to keep huge balance sheets, it becomes clear that, virtually everywhere, loans and deposits represent half of their assets. The maintenance of huge sovereign debt holding in Europe or the capital markets operations represent a threat to their stability that regulators are unwilling to tackle.
Furthermore, recent scandals such as the Libor crisis, the JP Morgan London Whale, the Monte dei Paschi di Siena collapse, the gold and the foreign exchange fixings can only confirm the reluctance of bank managements to tighten their ships. Regulation is not able to change the mindsets and the run for extravagant compensation.
Unless Boards of Directors become more competent and independent, and care about shareholders' value, management will continue to be virtually unchallenged. Servicing the economy is not on the agenda: only in advertisements. Ethical standards do not seem to have improved and the commitment to regulation hides lobbying efforts to weaken regulatory constraints.
Regulation must aim at financial stability
By focusing only on avoiding the use of taxpayers money, which is a legitimate concern, regulators have decided to create a structure of financial institutions that will enable them do bail themselves in rather than being bailed out.
It is only part of what could create financial stability. The complexities of the various recovery and resolution systems are such that the decision process as well as the remediation are unlikely to follow the textbooks.
It is through preventive measures that a solution will be found. However, history tells us that political maneuvering and the intimate relationship between finance and politics do not provide the level playing field necessary to impose the preventive measure in size and in time. The fact that those who bear the responsibility for the previous crisis remain unpunished and that the remedy has been found in outrageous fines rather than personal sanctions, leave a hugely skeptical taste in any serious observer of today's landscape.
Furthermore, it weakens the financial structure of banks at times when they badly need equity reinforcement. The United States has siphoned over $ 50 billion of banking equity through myriads of fines without any transparency on the destination of the funds. In Europe, no sanctions are applied.
Achieving financial stability will continue to require risk management skills, good governance, personal ethics, and, above all, courage to act to prevent further deterioration of finance.