Why Regulations Must Be Consistent Across Financial and Geographical Borders

Financial regulatory structures should look the same in different countries and across financial jurisdictions, said Malcolm Knight, vice chairman for Deutsch Bank global group and former general manager for the Bank for International Settlements. This will require filling in “very significant regulatory gaps.”

Otherwise the door is left open to regulatory arbitrage, which weakens stability of financial institutions, Knight said April 1 at Gleacher Center in a Myron Scholes Global Markets Forum, part of the Initiative on Global Markets.

“During the credit cycle upswing from 2002 to 2007, there was strong incentive for firms to take advantage of these gaps by engaging in regulatory arbitrage, and that made the financial system eventually a lot less robust,” he said.

Before the crisis, Knight said, many regulators operated under the assumption that “market discipline could be counted on to mitigate excessive risk-taking. So not surprisingly, during the upswing of the credit cycle, financial activity tended to migrate increasingly to jurisdictions that prided themselves on light-touch regulation.”

UK regulators, for example, allowed financial institutions to hold lower capital buffers than called for by the Basel II accord. “This looked like a significant competitive advantage” when London was attracting financial activity, “but it proved to be a significant weakness when the credit cycle and the deleveraging began,” Knight said.

Banks in the United States have delayed implementing Basel II standards and still operate under the Basel I accord, where no capital charge is required of structured investment vehicles and asset-backed securities of less than a year’s maturity, he said. With only a narrow scope of regulations on the “shadow banking system” of hedge funds and other institutions that act like banks, the private sector found “powerful” incentives to engage in regulatory arbitrage by transferring risks, “particularly credit risks in complex structures,” to this shadow banking system, Knight said.

“The interactions between financial institutions and markets make the financial system sometimes quite fragile in times of stress,” he said.

Knight cited these lessons learned from the economic crisis:

• Regulators must monitor system-wide risks and require institutions that act like banks to build up capital buffers, liquidity, and provisions as systemic risks rise. Central banks “very likely” would take on the role of a macro-prudential risk regulator.

• Distortions in competition and risk management, such as those resulting from delays in adapting Basel II, need to be immediately rectified.

• Regulation scope must be expanded to include hedge funds, private equity, and insurance firms. “The issue is not that the hedge funds and other institutions need to be supervised,” but that they need to register and inform authorities about their combined positions, Knight said. Capital adequacy rules also should be created, he said.

• Regulatory guidelines should achieve greater transparency.

• While regulation should not be “too intrusive,” Knight said, its framework should be consistent across financial jurisdictions and harmonized internationally.

Chicago Booth Faculty Raise Questions

Raghuram Rajan, Eric J. Gleacher Distinguished Service Professor of Finance, questioned the wisdom of having a single authority harmonize financial regulations. “Isn’t there more stability perhaps in allowing creative variety in regulation while making sure the regulation in each jurisdiction is transparent?” he asked, given that a central regulator’s rules might coordinate everybody to make the same mistakes.

“That is always a risk,” Knight agreed. But he maintained that rules can correct important distortions in the financial system, and such rules must be harmonized “because otherwise (particular financial) activity will escape that rule.”

He said a more fundamental problem is that it “just takes far too long to revise internationally harmonized standards like Basel I and Basel II, which seem to have inadequacies.”

Possible inadequacies in Fed strategy were addressed. Luigi Zingales, Robert C. McCormack Professor of Entrepreneurship and Finance and David G. Booth Faculty Fellow, discussed the so-called “Greenspan put,” the policies of the Alan Greenspan-led Fed. “There was a pretty strong conviction that the Fed will intervene, at every moment of crisis, to resolve the situation,” Zingales said. The market “correctly priced the fact that the Fed was providing a put for the market to ignore the systemic risk,” he said. The market reassessed risk level when Lehman Brothers went down.

Knight agreed that policy of a number of central banks was “far too expansionary” and that “there may have been too much of an asymmetry between the reluctance to lean against booms and the advertised willingness to mop up after a downturn.” Still, system problems mainly “lie in the fact that the buildup of systemic risk was not addressed by a requirement to build up capital cushions.”

Anil Kashyap, Edward Eagle Brown Professor of Economics and Finance, sought Knight’s opinion on a leaked communiqué from the G-20 summit about a dispute over accounting practices. “One view is that accounting should reflect the incurred losses that are embedded in the banking book as of today,” he said. The other view is “we have to take account of where we think things are headed; we ought to be provisioning against losses that aren’t incurred.”

Knight said he’d like to see “more forward-looking provisioning” on banking books, though “for the time being, we are stuck with a mixed valuation model.” But he said the trading book has to be based on fair value “because all the hedges are measured in fair value.”

Carlos Ganoza, first-year student in the Full-Time MBA Program, said he agreed with Knight’s vision of financial sector risks and the idea that banks should be “penalized with larger capital requirements if they grow beyond an acceptable threshold.”

Ganoza said he disagreed with Knight’s assessment of Basel II requirements, because European banks that were following those requirements faced similar problems to American banks that weren’t. And he said Knight “underestimated the affect of American monetary policy as a cause of the crisis.” A too-loose policy created the “Greenspan put,” where financial institutions’ decisions could be influenced by anticipation of rescue through Fed-lowered interest rates or a federal bailout.

                                                                                                                    — Mary Sue Penn