At the recent Mondo Visione Exchange Forum in London, longtime regulatory consultant Richard Britton read aloud a passage from the 126-page Turner Review (See “Credit Default Swaps: Still the Object of Desire,” Futures, April 2009), which was published by the UK’s Financial Services Authority (FSA) in March and authored by FSA Chairman Lord Adair Turner in response to regulatory failures leading up to last year’s financial crisis.
“If liquid traded markets are inherently subject to herd/momentum effects, with the potential for irrational overshoots around rational economic levels, then optimal regulation cannot be based on the assumption that increased liquidity is always and in all markets beneficial, but must recognize that there can be tradeoffs between technical efficiency and susceptibility to irrational herd effects,” he said.
It was a stunning passage, one essentially calling into question the long-standing assumption on the part of the FSA and regulators around the world that the more liquid a market is, the more efficient it is, and thus the better it serves us all.
The Turner Review was preceded at the European Union level by the de Larosière Report, named for Jacques de Larosière, who is chairman of the Strategic Committee of the French Treasury, and was followed by a May 7 conference at the European Parliament in Brussels entitled “Towards a New Supervisory Architecture in Europe.”
On May 27, the European Commission issued a proposal echoing sentiments expressed in these meetings and documents — namely, calls for new pan-European regulation of systemic risk, and more coordinated pan-European regulation of micro risk.
Specifically, the Commission and European Central Bank President Jean-Claude Trichet proposed a formal structure for something called the European Systemic Risk Council (ESRC, see “New regulator on the block”), which will “monitor and assess potential threats to financial stability that arise from macro-economic developments and from developments within the financial system as a whole.”
The ESRC will try to keep tabs on who owes what to whom and to sound the alarm if systemic risks build up.
“The creation of the ESRC will address one of the fundamental weaknesses highlighted by the crisis, which is the vulnerability of the financial system to interconnected, complex, sectoral and cross-sectoral systemic risks,” the report says.
This “macro-prudential supervision” would be complemented by a European System of Financial Supervisors (ESFS, see “Weaving the pan-European regulatory net ”), which would weave existing national regulators into a newly formed EU level entity that will provide “micro-prudential supervision,” or doing the standard things that regulators have been charged with, but hopefully doing them better and with more coordination, at least within the EU.
At press time, the EU’s Economic and Financial Affairs Council is preparing to debate the proposals, which will remain open to public comment until July 15.
The United States also is wrestling with how to deal with systemic risk, and Reuters says the Obama Administration wants to give that task to the Federal Reserve Bank. The Administration’s official proposals are expected by mid-June.
Whatever emerges, it’s clear that a completely new regulatory stage will be set by year-end, even if it’s populated by the same cast of regulatory characters.
TOO FAR OR JUST RIGHT?
In public, most market participants have been warm to the need for new regulation, although many who have been historically resistant to such intervention are hedging their endorsements with conditions that give them a seat at the table.
“We strongly believe that the ESRC could be supported in its task by a senior industry advisory panel,” says Ariane Obolensky, chair of the European Banking Federation’s Executive Committee. “Such a panel would provide the European Systemic Risk Council with expertise in the analysis of macro-financial developments.”
Many have endorsed the principle of keeping an eye on systemic risk, but urged restraint in rushing to create structures that will be around for years to come.
“We need to keep up the momentum, but at the same time we need to make sure that the changes envisaged are well thought-through and being given sufficient time for proper implementation,” says Karl-Peter Schackmann-Fallis, who serves on the board of the European Savings Banks Group. “In this context, we believe that the attempt to bring a new supervisory architecture into force by the end of 2010 jeopardizes the originally intended goal.”
That yellow flag was everywhere at the Mondo Visione event, both on the panels and in the halls. Alexander Justham, the FSA’s director of markets, sought to assure participants that regulators were proceeding with caution, and said they are merely questioning all premises, including the premise that liquid markets should be an end in themselves.
“The last two years have clearly demonstrated that the ‘liquidity is always good’ tenet is not as truthful as one would have maintained in the past,” he said, pointing out that the Turner quote raised by Britton referred to the short-term ban on short-selling, but was meant to challenge something more fundamental.
“Lord Turner is really saying that the economists and rational market theorists who have dominated regulatory thought over the past decade haven’t gotten things quite right, and we should not take their tenets as gospel.”
Adam Kinsley, director of regulation at the London Stock Exchange, conceded the point, but urged participants not to be shy about criticizing actions that may become codified in law.
“I understand there was a need for some measures on the part of regulators to prevent what was happening at the end of last year,” he said. “The danger now is that we’re entering a phase where regulators are trying to come up with solutions and respond to the crisis rather than to pursue long-term regulatory goals, and it would not be surprising if there were harmonized measures proposed for short selling and those measures will be with us forever.”
Another issue of concern is how far regulators should go in regulating not just markets, but the creation of products traded only among professionals.
Until recently, the feeling had been that institutional traders had the expertise, resources, and risk appetite to buy or sell whatever they wanted, while retail investors needed to be protected from their own ignorance. Now regulators around the world are toying with the notion that some financial products are, in words echoed by several participants, “too nuclear even for the grown-ups.”
Britton welcomes the focus on systemic risk, and even concedes that non-professionals may need some protection from their own folly. However, he’s leery of putting too much restraint on professionals if their activities don’t increase systemic risk.
“I can live with maximum loan-to-value ratios in mortgage lending,” he says. “But telling institutional investors that there are some things you should not be allowed to buy even if you think you can do the due diligence because we, the regulators, have decided that these things are too dangerous for you to buy is just scary.”
The FSA’s Justham again sought to assure participants that discussing extreme regulatory action isn’t the same as enacting it. “Lord Turner is flying the idea of product regulation, but I don’t think this is a formal stance — yet,” he says.
Several participants pointed out that regulators respond to legislators and that it was legislators who have been driving the “soft touch” regulation of the past decade.
“On both sides of the Atlantic, the political pressure has changed,” says Britton. “Now, any regulator who wants to go to his government and say, ‘I want to be tougher,’ will be told, ‘Great! In fact, we think maybe you’re not thinking tough enough!’ Many regulators will say to themselves, ‘the last few years were a big mistake, and this is our opportunity to right the wrongs that we committed at the behest of politicians over the last four or five years.’”
THINKING LOCAL ACTING LOCAL
International coordination among regulators seems to have become derailed in all the confusion of late, and several participants said the consequences of such a breakdown could have impacts well beyond the derivatives markets.
“The new European regulation on credit rating agencies is a case in point,” said Britton. “It’s much better now than it was in the first draft we saw at the end of last summer, but it still risks providing a large disincentive for emerging market jurisdictions who want to create reputable credit rating agencies domestically.”
That’s because it would force many of them to set up European subsidiaries.
“That’s an additional cost,” he says. “Europe should be helping the rest of the world to develop their capital markets, but this doesn’t do that.”
Robert Wasserman, the CFTC’s associate director of clearing and intermediary oversight, also conceded that international cooperation has taken a back seat, but says regulators are doing their best to stay in touch with each other. “We’re working together with European colleagues and other colleagues,” he says. “But we each have to respond to our national law, so we are bound by our statutes and our congress and we’ll continue on that way.”
Kinsley said he sensed a growing awareness of international trends among regulators, and that the long-term prospects for cross-border cooperation were good. “Long-term, there is a move towards more international convergence,” he said. “Clearly, we’re seeing a little bit of a wobble in that trend, because there needed to be reactions and there needed to be quick reactions, but I suspect that when we get out of this mess we’ll all be broadly moving in the same direction, so we can pick up that global convergence again.”
For Justham, the seeds of global coordination can be found in the credit default debacle itself. “The debate over how to deal with credit default swaps is going to have to be an international debate,” he said. “You can’t solve it in just one part of the global marketplace and think you’ve solved the problem, because you haven’t.”
What is clear is that regulation is no longer a four-letter word; this holds on both sides of the Atlantic. What is not clear is whether new measures will efficiently address the systematic risk of the last decade or whether regulators will simply rush in to put their stamp on all aspects of trading.