The systemic risk of international financial regulation (Part 2)

In Part 1 of this post, I looked at the way international financial regulation encouraged complexity and regulatory capture. In this part, I look at the problems of herd behaviour and the making of regulatory mistakes on a huge scale.

Encouraging common shocks and herding

Harmonisation of regulation is a recipe for herding and making mistakes on a big scale. We are in danger of creating a less diverse system in which the behaviour of institutions is likely to be more similar. This means that, when a random shock does come, it will affect more countries and more institutions at the same time.

Instead of the financial system being made up of institutions that see things differently, do different things, try different approaches to managing risk, and so on, we are promoting a system in which institutions behave in more similar ways and manage risks in more similar ways so that the system will fail catastrophically when it does fail.

Indeed, the classical approach to regulating banks is that you should try to regulate them so that they fail safely, without bringing down the financial system. The system needs to be protected, but we need to allow banks to fail. This worked in the Barings case, for example. The new approach to financial regulation seems to do the precise opposite. It requires institutions to hold so much capital that they will hardly ever fail (that is an explicit objective of policy), but, because they all have their regulatory capital determined in similar ways, when they do fail they will all fail at the same time.

As Avinash Persaud, former director of the Global Association of Risk Professionals put it: “Regulators must dare to consider what a resilient financial system would look like. I would venture that it is one where a shock in one part of the system can be absorbed by another part, and not spread and amplified across all the others. For this to happen, we need a financial system in which the different parts assess, value, hedge, and trade the same assets or activities differently”. He further argues that it is herd-like behaviour and not risky assets that creates catastrophic risks. He was arguing especially for heterogeneity in terms of the financial structure of institutions. Such heterogeneity is nurtured by not having prescriptive and uniform regulation.

The way in which shocks can be amplified if firms have similar systems of risk management, similar asset liabilities structures and similar methods of accounting was shown in the financial crisis, before which and then during which International Accounting Standards encouraged similar behaviours amongst affected banks. This behaviour then reinforced the problems caused by the crisis.

Evolution in regulation

And, of course, regulators do not get everything right. This is not because they lack competence, but because regulators come from the same strain of humanity as the rest of us. People might want harmonisation of regulations around the “right” rules – though I would be wary even of that for the reasons I have explained. However, we do not know the “right” rules in advance. And, if regulators get regulation wrong, it can promote herding towards behaviours that are especially risky.

For example, there are concerns that Solvency II will artificially encourage investment in government bonds and, if these prove to be of questionable credit risk, there is a danger of large insurance companies across the EU, encouraged by regulation, making the same mistake simultaneously.

We also saw this in the banking crisis. The Basel bank capital setting regime provided relatively high capital weights for mortgages even if they were not especially risky, but it had lower capital weights for securitised mortgages, especially if they had a strong credit rating. Sovereign bonds were also favourably treated. This distorted the activities of ratings agencies and of banks; it encouraged securitisation (which was already encouraged by US government guarantees); and it encouraged opacity. There were serious flaws in the Basel approach but they were flaws that affected many countries simultaneously and a huge number of institutions in the US simultaneously because of the international nature of the accord. Indeed, it is a curiosity that we now look at one country which did not do too badly out of the banking crisis – Canada – because it did not follow the international approach to regulation and argue that Canada’s approach should be adopted internationally!

Developing good regulation, like any other human activity, is a process of trial and error. We often get things wrong. Competition between states is healthy as things that work can be copied and things that don’t work can be discarded. We can learn from mistakes and regulatory competition can help prevent regulators from over-regulating. We would not, of course, have had the ludicrous restrictions on bankers’ bonuses – regulations which themselves increase risk – if it were not for the monopoly of regulation at the EU level.

In conclusion, I cannot summarise the problem much better than Yale law academic and NBER scholar Roberta Romano. As she put it: “Recent experience suggests that regulatory harmonization can increase, rather than decrease, systemic risk. By incentivizing financial institutions worldwide to follow broadly similar business strategies, regulatory error contributed to a global financial crisis […] there are bound to be regulatory mistakes, both large and small. Moreover, an internationally-harmonized regime impedes the acquisition of information concerning the comparative effectiveness of differing regulatory arrangements, lowering the quality of decision making, as nations are discouraged from experimenting with alternative regulatory arrangements.”

What do we do?

If international harmonisation is the problem, what should we do?

We should take more risks with under-regulation. Ever since 1980, we have been trying to control financial institutions with ever more regulation. It has not been a success.

Secondly, we should recognise that we do not need international regulation for the free flow of capital and free trade in services. Many financial institutions do work on an international basis in a relatively unregulated environment and, where regulation is necessary, the most successful regulatory practices are often developed by market institutions themselves.

Thirdly, we might have to recognise that banks – including within the EU – should have to have separate legal personalities in different countries, especially if they are the beneficiaries of deposit insurance. This is not regulation as such, and it is not an impediment to free trade – though it may raise the costs of trade – but it may be an essential requirement to ensure that banks can be subject to proper winding-up procedures. Of course, the EU does not like this idea because it would undermine the march to a single EU state.

There is an alternative to the never-ending attempts to create more and more complex and prescriptive international financial regulation.

Prof Philip Booth is the IEA’s Editorial and Programme Director and Professor of Insurance and Risk Management at Cass Business School.

Academic and Research Director, IEA

Philip Booth is Senior Academic Fellow at the Institute of Economic Affairs. He is also Director of the Vinson Centre and Professor of Economics at the University of Buckingham and Professor of Finance, Public Policy and Ethics at St. Mary’s University, Twickenham. He also holds the position of (interim) Director of Catholic Mission at St. Mary’s having previously been Director of Research and Public Engagement and Dean of the Faculty of Education, Humanities and Social Sciences. From 2002-2016, Philip was Academic and Research Director (previously, Editorial and Programme Director) at the IEA. From 2002-2015 he was Professor of Insurance and Risk Management at Cass Business School. He is a Senior Research Fellow in the Centre for Federal Studies at the University of Kent and Adjunct Professor in the School of Law, University of Notre Dame, Australia. Previously, Philip Booth worked for the Bank of England as an adviser on financial stability issues and he was also Associate Dean of Cass Business School and held various other academic positions at City University. He has written widely, including a number of books, on investment, finance, social insurance and pensions as well as on the relationship between Catholic social teaching and economics. He is Deputy Editor of Economic Affairs. Philip is a Fellow of the Royal Statistical Society, a Fellow of the Institute of Actuaries and an honorary member of the Society of Actuaries of Poland. He has previously worked in the investment department of Axa Equity and Law and was been involved in a number of projects to help develop actuarial professions and actuarial, finance and investment professional teaching programmes in Central and Eastern Europe. Philip has a BA in Economics from the University of Durham and a PhD from City University.