Tuesday, June 30

An interesting analogy in the discussion about the future of financial regulation

The hills are alive – and have been for many moons now - with the ideas on how to regulate financial products. The most recent were the proposals by President Obama. On the whole they were of interest because they recognise the fragmented nature of regulation and how systemic risk is important. So in fact they do not propose to reduce the regulators, but rather to adopt the overall ‘Department of Homeland Security Model’, or if you will, create a super regulator to oversee all the hodge podge of regulators in the US. Curiously nobody is touching the Basel 2 framework (but more about that later on). The FSA is pushing for a liquidity management framework which, while being - in my opinion - conceptually and intuitively appealing, is practically a nightmare to implement and execute. The EU is also going towards the super regulator direction, but I am still not convinced that a super regulator is the answer. It all boils down to giving regulators more data and more coverage and this kind of credit crisis will not happen again. But the regulators already had all this data, coverage and people. If banks are already being labelled as "if they are too big to fail, they are too big", then why isn't the same question being asked of the regulator? If the financial world thinks that banks are too big to manage, what makes them think that a vastly bigger overarching regulator can oversee an entire group of these giant banks?

The BIS is currently going to through some serious debates about the future of regulation. In yesterday's annual report, they threw a wide net across this issue, but in particular, page 126 uses a very curious analogy which I thought was interesting enough to share.

I quote:

Balancing innovation and safety in financial instruments requires providing scope for progress while limiting the capacity of any new instrument to weaken the system as a whole. Balance can be achieved by requiring some form of product registration that limits investor access to instruments according to their degree of safety. In a scheme analogous to the hierarchy controlling the availability of pharmaceuticals, the safest securities would, like non-prescription medicines, be available for purchase by everyone; next would be financial instruments available only to those with an authorisation, like prescription drugs; another level down would be securities available in only limited amounts to pre-screened individuals and institutions, like drugs in experimental trials; and, finally, at the lowest level would be securities that are deemed illegal. A new instrument would be rated or an existing one moved to a higher category of safety only after successful tests – the analogue of clinical trials. These would combine issuance in limited quantities in the real world with simulations of how the instrument would behave under severe stress. Such a registration and certification system creates transparency and enhances safety. But, as in the case of pharmaceutical manufacturers, there must be a mechanism for holding securities issuers accountable for the quality of what they sell. This will mean that issuers bear increased responsibility for the risk assessment of their products.

Regardless of how great an analogy this is, it still opens up questions. Four major questions emerge:

1. Who will be the FDA (USA), EMEA (Europe) or MHRA (UK) to judge the safety of these "drugs"? The point is that the problem with the rating agencies is well known already. (would be good to give an example here, such as …. Etc to drive home the point)

2. Do the regulators have the capacity and capability to really judge these financial products?

3. How will the Basel 2 process be modified to cater for this as this is taking risk rating down to a seriously detailed level and will require far more standardisation than before.

4.Given that the speed of introducing new products into the financial markets is measured in terms of days for example in the OTC derivatives market, this kind of product based regulation will be equivalent to dropping a JCB full of boulders into the world financial system.

Much to think about...

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