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8 days to G20: it’s raining recommendations — 101 and counting
Speaking only of official recommendations — that is, suggestions made by governments or regulators of G20 and not think tanks or economists — I have with me a master list that has crossed a century. Taking the 126 page The Turner Review, published by UK’s Financial Services Authority on March 18, 2009, which adds 32 of its own (listed at the bottom of this post), the total number of sovereign suggestions stands at 101 — and counting. Here’s the timeline.
First came the November 15, 2008 Washington Declaration that listed out six broad policy responses, five common principles of reform and request to the G20 finance ministers to formulate six additional recommendations. The rather overstated “action plan to implement principles for reform” had 47 — repeat forty-seven — recommendations.
Then came the communiqué that the finance ministers put together on March 14, 2009. “We agreed further action to restore global growth and support lending, and reforms to strengthen the global financial system,” the communiqué stated. All told, eight new “further actions” were suggested across two themes — restoring global growth and strengthening the financial system.
The March 19, 2009 leak of Macroeconomic Stability and Financial Regulation: Key Issues for the G20 — the final report of the first of the three working groups set up before the G20 meet — to breakingviews.com followed next. This contains 24 recommendations, which while put together the various issues that leaders of G20 will be confronting in the April 2, 2009 meeting, have accountability missing.
And now, The Turner Review — a product of FSA chairman Lord Turner who was asked by the UK’s Chancellor of the Exchequer to review the events that led to the financial crisis and to recommend reforms — which has been critiqued by some economists who call it “flawed”.
I find that the review does take a few steps forward on the incentives front. Recommendation 17 lays it out: “Remuneration policies should be designed to avoid incentives for undue risk taking; risk management considerations should be closely integrated into remuneration decisions. This should be achieved through the development and enforcement of UK and global codes.”
Here’s a footnote from the review that examines incentives and explains the conflict: “Thus, for instance, if a trader, a senior executive or an institution (e.g. a hedge fund) is remunerated on the basis of a contract which provides for a significant profit share in good years but no claw back in years of poor performance, that person or institution will have a strong incentive to pursue strategies which generate strong return in many years but at the expense of the small probability of occasional very large losses. Applied in general across the financial system, such contracts will result on average in excessive compensation relative to the economic functions performed.”
To that extent, I find the review (you can read a simpler and shorter press release here) moving in the right direction.
I think India needs to put together its own position out.
—
The Turner Review: Actions Required to Create a Stable and Effective Banking System
Capital adequacy, accounting and liquidity
1. The quality and quantity of overall capital in the global banking system should be increased, resulting in minimum regulatory requirements significantly above existing Basel rules. The transition to future rules should be carefully phased given the importance of maintaining bank lending in the current macroeconomic climate.
2. Capital required against trading book activities should be increased significantly (e.g. several times) and a fundamental review of the market risk capital regime (e.g. reliance on VAR measures for regulatory purposes) should be launched.
3. Regulators should take immediate action to ensure that the implementation of the current Basel II capital regime does not create unnecessary procyclicality; this can be achieved by using ‘through the cycle’ rather than ‘point in time’ measures of probabilities of default.
4. A counter-cyclical capital adequacy regime should be introduced, with capital buffers which increase in economic upswings and decrease in recessions.
5. Published accounts should also include buffers which anticipate potential future losses, through, for instance, the creation of an ‘Economic Cycle Reserve’.
6. A maximum gross leverage ratio should be introduced as a backstop discipline against excessive growth in absolute balance sheet size.
7. Liquidity regulation and supervision should be recognised as of equal importance to capital regulation.
* More intense and dedicated supervision of individual banks’ liquidity positions should be introduced, including the use of stress tests defined by regulators and covering system-wide risks.
* Introduction of a ‘core funding ratio’ to ensure sustainable funding of balance sheet growth should be considered.
Institutional and geographic coverage of regulation
8. Regulatory and supervisory coverage should follow the principle of economic substance not legal form.
9. Authorities should have the power to gather information on all significant unregulated financial institutions (e.g. hedge funds) to allow assessment of overall system-wide risks. Regulators should have the power to extend prudential regulation of capital and liquidity or impose other restrictions if any institution or group of institutions develops bank-like features that threaten financial stability and/or otherwise become systemically significant.
10. Offshore financial centres should be covered by global agreements on regulatory standards.
Deposit insurance
11. Retail deposit insurance should be sufficiently generous to ensure that the vast majority of retail depositors are protected against the impact of bank failure (note: already implemented in the UK).
12. Clear communication should be put in place to ensure that retail depositors understand the extent of deposit insurance cover.
UK Bank Resolution
13. A resolution regime which facilitates the orderly wind down of failed banks should be in place (already done via Banking Act 2009).
Credit rating agencies
14. Credit rating agencies should be subject to registration and supervision to ensure good governance and management of conflicts of interest and to ensure that credit ratings are only applied to securities for which a consistent rating is possible.
15. Rating agencies and regulators should ensure that communication to investors about the appropriate use of ratings makes clear that they are designed to carry inference for credit risk, not liquidity or market price.
16. There should be a fundamental review of the use of structured finance ratings in the Basel II framework.
Remuneration
17. Remuneration policies should be designed to avoid incentives for undue risk taking; risk management considerations should be closely integrated into remuneration decisions. This should be achieved through the development and enforcement of UK and global codes.
Credit Default Swap (CDS) market infrastructure
18. Clearing and central counterparty systems should be developed to cover the standardised contracts which account for the majority of CDS trading.
Macro-prudential analysis
19. Both the Bank of England and the FSA should be extensively and collaboratively involved in macro-prudential analysis and the identification of policy measures. Measures such as countercyclical capital and liquidity requirements should be used to offset these risks.
20. Institutions such as the IMF must have the resources and robust independence to do high quality macro-prudential analysis and if necessary to challenge conventional intellectual wisdoms and national policies.
FSA supervisory approach
21. The FSA should complete the implementation of its Supervisory Enhancement Program (SEP) which entails a major shift in its supervisory approach with:
* Increase in resources devoted to high impact firms and in particular to large complex banks.
* Focus on business models, strategies, risks and outcomes, rather than primarily on systems and processes.
* Focus on technical skills as well as probity of approved persons.
* Increased analysis of sectors and comparative analysis of firm performance.
* Investment in specialist prudential skills.
* More intensive information requirements on key risks (e.g. liquidity)
* A focus on remuneration policies
22. The SEP changes should be further reinforced by
* Development of capabilities in macro-prudential analysis
* A major intensification of the role the FSA plays in bank balance sheet analysis and in the oversight of accounting judgements.
Firm risk management and governance
23. The Walker Review should consider in particular:
* Whether changes in governance structure are required to increase the independence of risk management functions.
* The skill level and time commitment required for non-executive directors of large complex banks to perform effective oversight of risks and provide challenge to executive strategies.
Utility banking versus investment banking
24. New capital and liquidity requirements should be designed to constrain commercial banks’ role in risky proprietary trading activities. A more formal and complete legal distinction of ‘narrow banking’ from market making activities is not feasible.
Global cross-border banks
25. International coordination of bank supervision should be enhanced by
* The establishment and effective operation of colleges of supervisors for the largest complex and cross-border financial institutions.
* The pre-emptive development of crisis coordination mechanisms and contingency plans between supervisors, central banks and finance ministries.
26. The FSA should be prepared more actively to use its powers to require strongly capitalised local subsidiaries, local liquidity and limits to firm activity, if needed to complement improved international coordination.
European cross-border banks
27. A new European institution should be created which will be an independent authority with regulatory powers, a standard setter and overseer in the area of supervision, and will be significantly involved in macro-prudential analysis. This body should replace the Lamfalussy Committees. Supervision of individual firms should continue to be performed at national level.
28. The untenable present arrangements in relation to cross-border branch pass-porting rights should be changed through some combination of:
* Increased national powers to require subsidiarisation or to limit retail deposit taking
* Reforms to European deposit insurance rules which ensure the existence of pre-funded resources to support deposits in the event of a bank failure.
Open questions for further debate
29. Should the UK introduce product regulation of mortgage market Loan-to-Value (LTV) or Loan-to-Income (LTI)?
30. Should financial regulators be willing to impose restrictions on the design or use of wholesale market products (e.g. CDS)?
31. Does effective macro-prudential policy require the use of tools other than the variation of countercyclical capital and liquidity requirements e.g.
* Through the cycle variation of LTV or LTI ratios.
* Regulation of collateral margins (‘haircuts’) in derivatives contracts and secured financing transactions?
32. Should decisions on for instance short selling recognise the dangers of market irrationality as well as market abuse?
Also read:
9 days to G20: China likely to get influence support from Down Under…and other stories
10 days to G20: a reading list that hopes to change the world
11 days to G20: 24 recommendations but no breakthrough
12 days to G20: IMF’s spend-your-way-out-of-the-crisis recommendations are best ignored
13 days to G20: set broad principles, leave detailing to sovereigns
14 days to G20: no space for a common global financial regulator
15 days to G20: can India grab its geopolitical moment?
16 days to G20: will G20 bring solutions?
17 days to G20: look who’s driving the G20 agenda
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