Senior figures say complicated regulation threatens to make things worse for the financial system, not better. Call for return to simplicity
By David Keefe
There is growing concern among past and present regulators that the overwhelming complexity of financial regulation could backfire and have the unintended effect of hobbling effective supervision and crisis control.
In remarks to GRR, Sheila Bair, who as chairman of the Federal Deposit Insurance Corporation (FDIC) helped steer America through the 2007-09 global financial crisis, said she agreed fully with the criticisms of complexity made by Bank of England executive director Andrew Haldane in late August*.
“We’re drowning in complexity,” said Bair who now leads the Systemic Risk Council (SRC), a private-sector, non-partisan body that advocates better financial regulation with a focus on systemic risk. At the height of the financial crisis Bair was ranked by Forbes magazine as the second most powerful woman in the world after German chancellor Angela Merkel.
“The public is tired of rules they don’t understand,” she said, adding: “We should be simplifying the rules, we should be simplifying the institutions for which the rules are made, but it’s going in the opposite direction.”
She suggested in effect that a vicious circle was being created by the slow pace of reform, as exemplified by the incomplete implementation of America’s 2010 Dodd-Frank Wall Street Reform Act, coupled with the complexity of so many of the rules.
The more complex a rule is, the harder and longer it takes to finalise; the longer it takes to finalise a rule, the more watered down it gets under pressure from the financial services industry critics “who then turn around and criticise the regulators for being too bureaucratic with their lengthy rules,” she said.
Bair said she was in “wholehearted agreement” with Haldane’s attack on the complexity of regulation - made at the annual Jackson Hole, Wyoming get-together of central bankers - and his criticism of the use of models to set the level of regulatory capital banks need as a buffer to absorb shock losses.
Above all, Bair is fully behind Haldane’s advocacy of the risk-insensitive leverage ratio of capital to assets as a guide to a bank’s health. The leverage ratio is simpler and more efficient than risk-based capital ratios.
But Bair, who as FDIC chief fought for the leverage ratio to be included in the international Basel III bank reform package, is more protective of Basel III than Haldane. His Jackson Hole paper, written with Bank of England colleague Vasileios Madouros, was interpreted in some quarters as calling for the capital accord to be torn up and for a return to a few simple standards on capital and total borrowing.
There are “some very good things about Basel III in terms of improving the definition of what counts as capital, what counts as tangible common equity and, finally, the instituting of a leverage ratio,” Bair said.
Haldane, who is executive director for financial stability at the UK central bank, pointed out to fellow central bankers at Jackson Hole, that the first Basel bank capital accord weighed in at 30 pages long. Basel II, which was agreed in 2004 and formalised the use of banks’ internal models to set capital requirements, came in at 347 pages, while Basel III, which sets much tougher capital rules and introduces new liquidity requirements, comprises 616 pages.
“The length of the Basel rulebook, if anything, understates its complexity,” said Haldane who is on the Basel Committee of global banking supervisors that’s responsible for devising Basel III.
Analysts said Haldane’s views were more nuanced than some commentators allowed and that he was simply arguing for a re-think on models, a greater role for the leverage ratio and a “delayering” of the complexity of Basel III.
Haldane suggests simplification and streamlining the framework might be achieved through a combination of five mutually-supporting policy measures: a delayering of the Basel structure; placing leverage on a stronger regulatory footing; strengthening supervisory discretion and market discipline; regulating complexity explicitly; and structurally re-configuring the financial system.
“I think Haldane’s speech was as much an attack on the Basel II advanced approaches [to modelling risk], which he has done before, and I wholeheartedly agree with him,” Bair said.
Bair’s remarks reflected her long-standing advocacy of the leverage ratio. As chairman of the FDIC, the federal banking supervisory agency that insures customer deposits at America’s banks, she insisted on stricter capital requirements than those proposed by the international accord. Her demands helped stall the introduction of Basel II in the US because she wanted the package to include the leverage ratio that now forms such an important element of Basel III.
After she had fought Basel II for so many years because it resulted in precipitous capital declines, Blair said it would be “disheartening” to disown Basel III which is designed to correct Basel II’s faults.
“The evidence shows that for the larger institutions that got in trouble during the crisis, the leverage ratio was a much better predictor than a risk-based ratio of whether they were going to fail or not. It’s simple, it’s easier for examiners to enforce and it’s easier to understand,” Blair says.
Like any simple rule, the leverage ratio is less subject to gaming. And while it’s true the leverage ratio is less risk sensitive, there’s a supervisory process that accompanies it. However, a good risk-based ratio should capture a bank loading up on risk, Bair says, adding that she had always said that both types of ratio are needed.
At present the Basel III rules prescribe a 3% leverage ratio, which Haldane noted means bank equity can in principle be leveraged up to 33 times. Most banks would say a loan-to-value ratio of 97% was imprudent for a borrower, Haldane said, although a 3% leverage ratio means banks are just such a borrower. For the world’s largest banks, the leverage ratio needed to guard against failure in the crisis would have been above 7%, he noted.
Blair said that in terms of complexity, she would focus on Basel II and the use of models in the advanced approaches to measuring risk.
“I think we should get rid of the advanced approaches, using the simpler standardised approach for the risk-based capital ratios. We need to put a lot more emphasis on the leverage ratio to constrain risk at institutions.”
In respect of Basel III in the US, where regulators have extended the comment period on the implementation proposals to October 22, Bair said there’s still an issue with complexity, despite many analysts believing the US version of Basel III to be simpler than the international accord.
“It’s all focused on the risk-based rules and my personal view is those rules need to be simplified. I don’t think models have any place in setting regulatory capital. I think models are fine as part of your risk management tools, but they’re not reliable,” she said.
And just how unreliable was seen recently with the so-called “London Whale” fiasco, J P Morgan Chase’s multi-billion dollar derivatives trading blunder.
“London Whale shows that if you let banks use models to set their regulatory capital, they will have incentives to have a model that gives lower capital,” she said.
Bair believes Basel III will go into effect in America, although meeting the January 2013 implementation deadline may be a tough proposition given the extension of the comment deadline to October 22.
Since June Bair, who left the FDIC last year after a five-year stint as chairman, has chaired the SRC. The Council comprises a diverse group of experts in investment, capital markets and securities market regulation, including former Federal Reserve chairman Paul Volcker, sponsor of the Volcker Rule banning banks from proprietary trading under the Dodd-Frank Act.
Systemic Risk Council
Concerns over the slow progress of regulators and standard-setters prompted the creation of the SRC. The council has said it will monitor and evaluate the activities of those with the Congressional mandate to develop and implement Dodd-Frank provisions related to systemic risk, including the Financial Stability Oversight Council (FSOC), America’s systemic risk watchdog, and the Office of Financial Research, the bureau set up within the US Treasury to improve the quality of financial data available to policymakers.
The SRC expects to evaluate and provide commentary on the existing efforts of regulators to design and implement a credible and globally-coordinated systemic risk oversight function. Activities include reports and commentary to the FSOC and its member regulators as they adopt regulations to prevent a repeat of the global financial crisis.
Bair said she was deeply frustrated with the slow pace of reform in the US.
“I am disappointed and dismayed. Regulators need to aim for simplicity and finalise these reforms,” she said of Dodd-Frank, enacted two years ago but still only a third to a half implemented. But she acknowledged it’s harder to write a simple rule than a complex one.
“We can’t even get things done like money market mutual fund reform,” Bair adds, referring to the failure of the Securities and Exchange Commission (SEC) in August to agree on reforms of the $2.7 trillion US money market fund industry (see page 1).
It’s extremely disheartening that three of the five SEC Commissioners didn’t back SEC chairman Mary Schapiro’s reforms, Bair said. The irony is that the SEC had watered down the original proposals. Meanwhile, money market funds remain a potential source of instability in the financial system, she noted.
The SRC, which strongly supports Schapiro’s proposals, made clear early on that the risk that emergency government support may again be needed to stem large outflows from money market funds remains a serious challenge for US and other markets. In the event of the SEC failing to act promptly on these measures, the FSOC should use its powers under Dodd-Frank to move forward with reforms to protect taxpayers against the risk of a need for bailouts in the future, the SRC said.
But in her remarks to GRR, Bair acknowledge that FSOC has no power to intervene directly. Unfortunately, the FSOC can’t write its own rules, so it has to follow a circuitous process if it thinks a particular regulatory agency isn’t dealing with a systemic problem, Bair said.
On the controversial Volcker rule banning proprietary trading, she said her personal view was that anything to do with proprietary trading should be walled off from federally insured banks but accepts this is not going to happen.
She said it was extremely difficult to distinguish market-making from proprietary trading because market-making needs inventory to meet customer demand and that means in effect taking market positions in order to maintain inventory.
Banning any profits made from hedge transactions would be one way of curtailing the use of hedging as a ruse for proprietary trading. Greater transparency and disclosure of the models used for trading would be helpful in determining exactly what banks were up to, Blair said but noted that there’s no provision for that in the rule.
*The dog and the frisbee – paper by Andrew Haldane and Vasileios Madouros, Bank of England, August 2012 .