Regulators respond to financial crisis - Jonathan Watson

In the wake of the financial crisis, political leaders want to tighten international regulation of the financial sector. Is a single all-powerful global regulator the answer?

‘Since July 2007, the world has faced, and continues to face, the most serious and disruptive financial crisis since 1929. Originating primarily in the United States, the crisis is now global, deep, even worsening. It has proven to be highly contagious and complex, rippling rapidly through different market segments and countries. Many parts of the financial system remain under severe strain. Some markets and institutions have stopped functioning. This, in turn, has negatively affected the real economy. Financial markets depend on trust. But much of this trust has evaporated.’

This is the opening paragraph from the recent report published by the European Commission’s High-Level Expert Group on EU financial supervision, chaired by Jacques de Larosière, former Managing Director of the International Monetary Fund (IMF) and former governor of the Bank of France. It offers a useful summary of the problems currently facing the world’s political leaders and financial regulators. Understandably, most political leaders have reacted to the crisis by calling for tighter regulation of the financial services sector. Shortly before April’s G20 London summit, which brought together the leaders of the world’s largest economies, French president Nicolas Sarkozy and German chancellor Angela Merkel wrote a joint letter to EU heads of state in which they spoke of the need for a ‘new global financial architecture’. They said they were ‘determined to obtain concrete results on international financial regulation at the London summit’. There were even suggestions that Sarkozy might walk out of the summit if he did not get what he wanted. On the other side of the Atlantic, the newly appointed US Treasury Secretary Tim Geithner spoke of the need to ‘work with Europe on a global framework, a global infrastructure which has appropriate global oversight’.

‘It is simply not conceivable that we would have a global regulator that would tell global banks how to do their mortgage-based lending in different countries’

Hendrik Haag
Hengeler Mueller

However, the G20 communiqué published at the London summit did not endorse the idea of a global ‘super-regulator’. Despite the political posturing that preceded the event, this did not come as a surprise to those familiar with the financial sector. ‘Regulation is not simply about the global stability of the financial system’, says Hendrik Haag, a partner in the Frankfurt office of Hengeler Mueller and Chair of the IBA Legal Practice Division and a member of the IBA’s Task Force on the Financial Crisis. ‘It goes much deeper than that, all the way down into regulating retail products. It is simply not conceivable that we would have a global regulator that would, for example, tell global banks how to do their mortgage-based lending in different countries. The markets are just too different, and a global regulator could never be close enough to each one.’

Philip Wood, a partner at Allen & Overy and another member of the IBA task force, concurs:

‘The main problem with the idea of a superregulator is that it’s not going to be possible, because politically no one is going to agree to that. Even if it were possible, you would either end up with a monolithic, despotic body, or one that is too weak, like the United Nations or the League of Nations. Either they would be unaccountable, because it is very difficult to achieve international accountability, or harmless, in which case they would not be doing their job.’

Significantly, the de Larosière report chose not to recommend an all-powerful super-regulator for Europe. It proposed a dual-level approach to reform instead, consisting of new oversight of broad, system-wide risks and stronger coordination among national supervisors for day-to-day oversight. The report suggested that changes should be phased in over four years.

An ‘overarching global financial regulatory group’

However, the G20 London summit did agree to create the Financial Stability Board (FSB), an enlarged version of the Financial Stability Forum (FSF). The FSF is an advisory group established in 1999 to promote international financial stability through better information exchange and international cooperation. The new FSB will include all G20 countries, Spain and the European Commission. Based at the headquarters of the Bank for International Settlements in Basel, Switzerland, its role will be to ‘collaborate with the IMF to provide early warning of macroeconomic and financial risks and the actions needed to address them’. Financial Times journalist Gillian Tett said the FSB would be ‘the nearest thing the world has to a prototype of an overarching global financial regulatory group’.

The FSB’s job description means ‘they have to tell us if there’s a bubble coming up’, says Wood. ‘The issue is – will they? And the answer is – probably not. In this last crisis, people didn’t realise there was a bubble. Those who did were treated as doomsters and pessimists. If a regulator had said in 2006 that banks have to stop lending to poor people, how would that have been received? If it was proposed that no one must have more than a 60 per cent loan, and the rest they must provide themselves, it would have been considered a wicked suggestion.’

Gérard Hertig, professor of law and economics at the Swiss Federal Institute of Technology in Zurich, is also sceptical about the FSB.

‘It’s a good idea to have a macro prudential authority that informs supervisors if they think a crisis is coming, but how would they see it coming? They would not be able to “cry wolf” too often. They would have to be pretty sure, and as there are quite a few people involved in the FSB, it is going to be quite complicated getting them all to agree on what constitutes a crisis. The FSB might be helpful in addition to other things, but it’s difficult to see how it would work in practice.’

Haag is pleased that the scope of the FSF has been expanded. ‘The FSF grew out of the work of the Basel committee on banking supervision’, he says.

‘It now includes not only the banking industry but also the insurance industry, which I think is an important step forward. This has been prompted by the AIG disaster. Insurance used to be a totally different business, but with the advent of credit default swaps (CDS) you could see many insurance companies going into the CDS market and also becoming part of the problem. I wish the FSB good luck, but I think the debate is still ahead of us about what’s going to be required in terms of higher capital standards.’

‘If a regulator had said in 2006 that banks have to stop lending to poor people, how would that have been received?’

Philip Wood
Allen & Overy

National reform will lead to international convergence

While the debate over international institutions continues, it remains clear that regulatory convergence is likely to develop on a market-by-market basis. ‘There will be stricter national regulation’, says Stephen Revell, a partner in the London office of Freshfields Bruckhaus Deringer and Chair of the IBA Anti-Money Laundering Legislation Implementation Group. ‘Nationally, there will be a new approach focusing on putting more capital aside, and there will be more extensive/detailed regulation of the banking industry on a country-by-country basis. More rules, fewer principles. There will be quite a lot of international cooperation as to the level of that regulation. Regulators will seek to avoid regulatory arbitrage and will seek to use capital rules which build on the Basel capital rules. However, I think it unlikely that there will be a single regulator, even in the EU and even for cross border banks.’

Ed Greene, a partner based in the New York office of Cleary Gottlieb Steen & Hamilton, thinks that the financial crisis has damaged the standing of the US regulatory approach and that this will make international cooperation less likely. ‘There is an acceptance in most markets that the system has to be repaired’, he says:

‘Whereas before, there might have been more coordination, especially with the US, one of the sad consequences of the Madoff case and the collapse of Lehman Brothers among other things is that there is no longer the respect for the US regulatory approach in Europe or elsewhere. The Europeans are already going forward with regulatory reform as they see fit.’

This loss of confidence in the US regulatory model also means that the idea that Europe needs its own version of the US Securities and Exchange Commission (SEC) has been consigned to the past. ‘I don’t see any need for a common securities regulator in Europe’, says Haag.

‘I would hope for much closer cooperation between the bank supervisors, be it only on the CEBS (Committee of European Banking Supervisors) level or somewhere else, and for much more coordinated action when it comes to financial difficulties of a bank with systemic relevance. The system had worked quite well in Europe. The biggest mistake was the Lehman insolvency. No one in Europe would have let that happen. Lehman accelerated the development of the crisis in a totally unexpected way.’

According to Maarten Gelderman, head of quantitative risk management at the Dutch central bank, convergence in Europe is already well under way. ‘Article 129 of the EU’s Capital Requirements Directive means that regulators have to make a lot of decisions together in the college of supervisors when dealing with international banks,’ he says. ‘For the insurance sector, we are moving even further, towards binding intermediation. This means that for internationally active insurance conglomerates, we have to reach a lot of decisions together. There is also a possibility, if we don’t agree, to escalate it to the Commission of European Insurance and Occupational Pensions Supervisors (CEIOPS) in order to get this binding intermediation procedure and make sure that everyone is on the same track. This is a process that will move almost towards full convergence within the EU.’

Further information

Report of the High-Level Group on Financial Supervision in the EU [http://bit.ly/mw8Wr (PDF document, 440 KB)]
For more information on the IBA’s Task Force on the Financial Crisis, [visit www.ibanet.org/LPD/Task_Force_on_the_Financial_Crisis.aspx]

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Jonathan Watson is a journalist specialising in European business, legal and regulatory developments. He can be contacted by e-mail at watsonjonathan@yahoo.co.uk