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These include forcing banks to set aside more capital during good times, increasing scrutiny of ratings agencies, broadening the regulatory umbrella to capture all institutions that pose a potential risk to financial stability, setting up central clearing and settlement for over-the-counter derivatives and overhauling banks’ bonus policies. The authors also agree that regulators and central banks must in future be explicitly charged with spotting problems as they build up in the system and be given the power to prick future bubbles before they grow too large.
ELEMENTS OF A NEW ORDER
Who does what right now?
●Global bodies, such as the Basel Committee on Banking Supervision, agree policy.
●Decisions are adopted by local supervisors. In some cases, such as in the European Union, these are enshrined in law.
●National regulators ensure implementation of rules and scrutinise local institutions.
●In Europe, a system of committees seeks to ensure a consistent approach.
What is being proposed?
●Increased capital reserves for banks and a requirement they build up reserves during boom periods.
●Consistent regulation of any institution capable of disrupting the stability of the system.
●A crackdown on ratings agencies.
●Central clearing and settlement for over-the-counter derivatives.
●An overhaul of bonus systems to encourage long-term thinking, with clawbacks
of bonuses based on profits that turn into losses.
● A system of macro-prudential regulation to prick future bubbles.
Who will do what in the future?
●Beefed-up international bodies, such as the Financial Stability Forum, can oversee global regulation. Membership of the FSF and Basel Committee will include developing nations.
● Pan-European regulators will oversee consistent regulation and resolve disputes.
●The US patchwork will end, with regulatory power consolidated probably in the Fed.
What is still to be resolved?
●A cross-border system for allocating the costs of bailing out failing banks.
●A resolution regime, consistent across borders, that allows even large institutions to be closed down in an orderly way.
●Whether investment banking should be separated from commercial banking.
The new approach is based on an acknowledgement that the market cannot be counted on to limit excess. “The financial crisis has challenged the intellectual assumptions on which previous regulatory approaches were largely built, and in particular the theory of rational and self-correcting markets,” Lord Turner declared this month. “Much financial innovation has proved of little value, and market discipline of individual bank strategies has often proved ineffective.”
A particular source of concern is those institutions that are deemed too large to be allowed to fail. One option is to submit them to even more intrusive regulation to minimise the risk of a collapse. “Any firm whose failure would pose a systemic risk must receive especially closesupervisory oversight of its risk-taking, risk management and financial condition, and be held to high capital and liquidity standards,” Ben Bernanke, Fed chairman, said in a speech this month.
An alternative is to force banks to become smaller by preventing them from combining different business lines under one roof. This approach recalls Glass-Steagall, the Depression-era US law that separated investment banking from commercial banking and defined the shape of US financial services until it was repealed in the late 1990s.
Mervyn King, governor of the Bank of England, recently called for a “public and informed debate” on the issue. Others are less convinced it is possible to draw a line between activities. What is more, while laws remain static, institutions evolve. Ten years ago, Bear Stearns could probably have failed without dragging down the system. But although it had not crossed over into retail banking, Bear’s position as a counterparty in derivatives meant it posed a threat when it got into trouble a year ago, forcing the Fed to organise a bail-out. “Is there such a thing as a non-regulated part of the financial sector that you can afford to ignore?” asks the chief executive of a large US bank.
Mr Bernanke is pushing to broaden the rules, which currently apply only to banks regulated by the Federal Deposit Insurance Corporation, to include all significant institutions. This would also help prevent banks from acting recklessly in the knowledge they will be saved, he argued this month, saying: “Improved resolution procedures...would help reduce the too-big-to-fail problem by narrowing the range of circumstances that might be expected to prompt government intervention to keep the firm operating.”
What is the outlook for banking?
Regulators have taken some sensible steps. When scrutinising global banks such as HSBC, they have organised “colleges” of supervisors, with representatives from each country where the bank has a significant presence. Mr de Larosière also proposes creating a pan-European regulator called the European System of Financial Supervision, which could enforce common standards among regulators. To the surprise of many, Lord Turner endorsed the idea.
Yet any discussion of greater co-operation between regulators is incomplete without some agreement on who should pay the bill. In the current crisis, taxpayers in the bank’s home country have tended to bear the costs of a bail-out. As Lord Turner says Mr King once quipped: “Global banks are global in life and national in death.”
This is far from ideal. As the meltdown in Iceland last autumn showed, an economy can be overwhelmed by its banking system. Equally, the few cross-border bail-outs attempted so far have ended in disaster. A senior European financial executive points out that the board of Mr de Larosière’s proposed ESFS would have 27 members: hardly a grouping capable of swift action. “There is a real risk we may not have a European financial system unless this is addressed,” he says.
DEVELOPING WORLD
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