Redefining the perimeter of prudential oversight: are current reform proposals on the right track?

Por Augusto de la Torre y Alain Ize

(This note draws heavily on de la Torre and Ize’s papers “Regulatory Reform: Integrating Paradigms” and “Containing Systemic Risk: A Financial Paradigms View”. The views in this note are entirely those of the authors and do not necessarily represent the views of the World Bank, its executive directors and the countries they represent.)

Important progress is being made on the road to reforming prudential regulation. A number of important reports have already seen the light of day, a reform bill is before the U.S. Congress, and significant international coordination efforts are in motion under the G-20 process and the Financial Stability Board (see, for instance, Brunnermeier et al (2009), Acharya and Richardson (2009), the April 2009 Declaration of the G-20 Summit, and the Warwick Commission Report (2009)).  In particular, specific proposals have been made on how far to extend prudential regulation and to what institutions. Views appear to be converging on the notion that systemically important financial institutions, whether commercial banks, investment banks, or any other, should be identified up-front and regulated differently from other financial institutions. While the goal of this proposal—to contain systemic risk more effectively—is indeed right on the mark, the way the proposal is formulated has important shortcomings and fails to incorporate key lessons from the crisis.

The current regulatory regime rests on three key pillars: i) prudential norms that seek to align principal and agent incentives ex ante; ii) an ex post safety net aimed at enticing small depositors to join the banking system, as well as forestalling contagious runs on otherwise solvent institutions; and iii) a line-in-the-sand separating the world of the prudentially regulated (mainly commercial banking) from that of the unregulated. Informed investors should be fully responsible for their investments and live with the consequences of their mistakes. Moreover, regulation can hinder intermediation, financial innovation, and competition, and requires good supervision, which is costly. Finally, oversight on the cheap can also exacerbate moral hazard by giving poorly regulated intermediaries an undeserved “quality” label and an easy scapegoat (blame the regulator if there is a problem). Consistent with this rationale, only deposit-taking intermediaries are prudentially fully regulated and supervised. In exchange, and reflecting their systemic importance, they benefit from a safety net. Other financial intermediaries (and all other capital market players) neither enjoy the safety net nor are burdened by full-blown prudential norms. Instead, they are subject mostly (if not only) to market discipline, enhanced by securities market regulations focused on transparency, governance, investor protection, market integrity, and the like.

As a matter of historical fact, however, the line-in-the-sand became porous and was widely breached during the build-up to the Subprime crisis, as highly-leveraged intermediation spilled into “shadow banking” outside the confines of traditional banking, and the safety net had to be eventually sharply expanded, from the regulated to the unregulated. By exacerbating dynamic regulatory arbitrage, the intent of the Glass-Steagall Act—to shift risk away from regulated intermediaries to capital markets and unregulated intermediaries—fundamentally misfired. Well-informed investors can monitor the intermediaries to make sure they do not “cheat them”. However, they have no incentives to “internalize” systemic liquidity risk and other collective action frictions. Thus, the side-by-side existence of a regulated sector, where systemic concerns were partially factored in, and an unregulated sector, where externalities were not at all internalized, created a wedge in returns between the two worlds, giving rise to a fundamentally unstable construct (oddly enough, the Glass-Steagall Act resulted in a one-two punch on the soundness of financial intermediaries. Its introduction boosted systemic risk outside commercial banking. Once this was done, its repeal under the pressures of competition, boosted systemic risk within the commercial banking system itself. To compete with the blown-up investment banks under much stricter regulations, commercial banks had to find creative ways to shed their regulatory burden outside their balance sheet).

In this context, the path of regulatory reform that has been recently followed in the US looks in part like a return to the failings of the past. It seeks to expand the perimeter of “hard” regulation to the bounded set of intermediaries that are thought to be “systemically important”. The criterion proposed for inclusion in this set is typically based on the size or interconnectedness of all intermediaries, not just commercial banks. While a commendable effort is thus made to adjust the boundary of regulation to reflect systemic concerns, collective action frictions would be internalized only by the set of “systemically important institutions”. Other intermediaries would be mostly left alone, much as was the case of the non commercial bank intermediaries under the Glass-Steagall Act.

The basic problem with this approach is the discontinuity created by the boundary—the side-by-side coexistence of different regulatory regimes. This will plant new seeds for dynamic regulatory arbitrage, setting again in motion forces of structural instability. Financial activity is likely to increasingly migrate outside the perimeter. It would do so not so much to take advantage of the less informed or shift risks to the government, but mainly to better align private costs and risks—i.e., to more freely avoid having to internalize externalities. This risk will increase once prudential regulation is strengthened to better induce the intermediaries living within the perimeter to internalize systemic risk. Moreover, any sharply defined regulatory perimeter is bound to create bunching effects where intermediaries crowd in on the more favorable side of the boundary. In the process, unregulated systemic risk is likely to build up just outside the boundary.

To be sure, while inducing dynamic regulatory arbitrage, a different, more stringent regulatory treatment of “systemically important” intermediaries can compensate for the competitive advantages they derive from their too-big-to-fail or too-interconnected-to-fail (TBTF-TITF) de-facto status. However, getting the balance right even in this regard is likely to be an impossible task, all the more so since the differential regulation under current proposals is not presumed to be institution-specific but to apply equally across the whole class of systemically-relevant intermediaries. What may be right for the median institution within this set won’t be right for the institutions at the tails.

Moreover, to account for changes in the fabric of intermediation over time (including those deriving from dynamic regulatory arbitrage), the approach would need to rely on continuous regulatory adjustments, including the regular listing and de-listing of “systemically important” institutions. If history is any guide, however, the experience of the Glass-Steagall Act strongly suggests that such an adaptive approach is fraught with danger. Regulators can fall prey to regulatory capture, or else remain unaware of the looming risks percolating and growing in the shadows until it is too late for action. In this case, regulatory inertia is likely to be compounded by the very stark signaling implications of a change in regulatory status. A shift from the “systemically important” list to the “systemically unimportant” list, or vice versa, will unavoidably induce changes in the perceived too-big-to-fail status of the institutions.

We think a much preferable approach would be to apply a risk metric that incorporates systemic effects uniformly across all intermediaries within an expanded perimeter (such a metric might look like the recently proposed CoVar or some similar alternative such as CoEs; see Adrian and Brunnermeier (2009)). The perimeter of prudential regulation would be expanded to cover all leveraged intermediaries that borrow (directly, indirectly, or via contingent contracts) from the public or in the wholesale funding markets—that is, in the markets for large deposits and/or the professional money and capital markets. To engage in financial intermediation thus defined without a license would be illegal. Provided that the potential grey zones between financial and nonfinancial firms are strengthened to prevent nonfinancial corporations such as department stores from engaging in de-facto financial intermediation, this approach would eliminate the undesirable discontinuity effect of the boundary. The universe of financial intermediaries would thus be subject to a level playing field of risk-based prudential rules.

This approach to setting the regulatory perimeter would be more effective if accompanied by a universal intermediation license, thereby eliminating regulatory silos. But if a universal intermediation license is unfeasible and separate licenses (associated with separate prudential regulators) have to remain, a close substitute would be a functional approach to regulation—i.e., to ensure that similar activities and financial products would be similarly regulated, independently of the license under which they are produced.

Regulated financial intermediaries would under this proposal face the same regulation for risk taking at the margin. They would thus be free to specialize into distinct business models and financial activities, generating distinct asset and liability portfolios. However, such diversification would be the result of exploiting natural business advantages and risk niches under uniform regulatory rules, rather than the expression of regulatory arbitrage under uneven rules. This approach contrasts starkly with the views expressed in some recent reports, which specifically praise the benefits of “unlevel playing fields” and view the role of regulators as that of actively favoring the transfer of particular risks to those institutions that are better able to manage those risks on account of their current business models and portfolios (see for example the Warwick Commission Report (2009)). By putting excessive reliance on just-in-time and just-right reactive regulation, an unlevel playing field would exacerbate regulatory arbitrage and promote hidden risks in ways that the regulators are all too likely to miss, for the reasons already cited. Instead, we view the distribution of risks as a general equilibrium process where financial structure and risk-taking should respond to well-defined, uniform, and predictable regulation (albeit no doubt improving over time). Market forces would thus determine an efficiency-enhancing diversity of average portfolios and risks based on an identical regulation of marginal risks.

No doubt, implementing a healthy interplay between a level playing field of regulation and a comparative advantage-driven evolution of financial structure would involve at the outset very substantial changes in regulatory philosophy and practice. In particular, a consistent risk-based regulatory approach that has a uniform marginal effect on risk taking would need to be developed.  This is no doubt a daunting task, and one that in some respects seems to have lost favor following the Subprime debacle. In effect, important proposals under discussion advocate putting less emphasis on Basel II-style risk-based approach to regulation and more emphasis on rough-and-ready (yet admittedly blunt) prudential instruments such as a ceiling on the leverage ratio. However, as was the case with Basel I, such rough instruments are prone to affecting institutions with different business models differently, thereby promoting regulatory arbitrage. While the uniform risk-based approach we envisage would be initially harder to implement and might even increase risks in the shorter term, it would have a much better chance of sustainable success over the longer run.

We would recommend in addition that all prudentially regulated financial intermediaries have equal access to the lender-of-last-resort facilities as well as to the deposit insurance if they are deposit takers. However, to limit moral hazard and properly align incentives, the benefits of such an access should be priced in ex-ante through Pigovian taxation and a systemically-adjusted premium on liquidity insurance.

The definition of the regulatory perimeter proposed above would not necessarily rule out the existence of unregulated financial intermediaries. In effect, we would allow prudentially unregulated (but licensed) financial intermediaries to operate freely, as long as they only borrow from the regulated. Because the unregulated intermediaries would not need to meet entry requirements, this scheme would favor innovation and competition. Of course, for this scheme to work properly, all relevant credit risk (on and off-balance sheet) exposures acquired by regulated intermediaries would have to be covered by adequate capital and other prudential regulations. This would ensure sufficient “skin in the game” so that the activities of the unregulated would be adequately monitored through their contractual relationships with the regulated intermediaries that lend to them. This, in turn, would limit the cost of oversight.

While the unregulated intermediaries should be allowed to fail under efficient resolution mechanisms, the potential systemic ripple effects of such failures would be contained through the access of the regulated intermediaries to the safety net. Nor should such a regulatory discontinuity introduce any distortion or cause any opportunity for arbitrage. Because the unregulated intermediaries could fund themselves only from the regulated, a dollar lent to a final borrower through an unregulated intermediary would end up paying the same Pigovian tax as a dollar lent through a regulated intermediary. Systemic risk would thus be evenly internalized across all possible paths of financial intermediation.

Admittedly, this proposal does not of itself address the TBTF-TITF problem. But this is not as severe a shortcoming as it may seem, for several reasons. First, it is simply wrong to equate systemic risk with TBTF-TITF. Systemic risk can be present even without TBTF-TITF. Second, systemic risk is not addressed by fueling regulatory arbitrage (which applying stricter prudential regulations applied only to TBTF-TITF institutions would most probably do) but by removing (or at least lessening) the root causes leading to systemic events. A uniformly applied systemic liquidity tax would be an important step toward this goal. Third, stricter regulation would be of little or no help if a TBTF-TITF institution becomes troubled or unviable. That scenario, which is the main concern of proponents of tougher regulations for such institutions, calls for different instruments, chiefly a suitable framework for resolution of failed institutions—with powers to undertake such actions as closing, intervening in, and restructuring institutions; unwinding positions; and separating the “good” and “bad” parts of the balance sheet (current proposals to require that all large financial institutions prepare a living will facilitating their resolution when in trouble seem to be a step in the right direction. Draft bills seeking new failure resolution authority are in different stages of preparation and discussion in the United States, United Kingdom, and the European Union).

Augusto de la Torre es Economista en Jefe del Banco Mundial para America Latina y el Caribe. Alain Ize es consultor senior del Banco Mundial y actualmente es profesor visitante del CEE de El Colegio de México.


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