Voluntary self-regulation on a global scale may be the answer to controlling systemic risk to the financial system, according to some industry participants. For others, such an approach could accentuate the very problems it is trying to solve.
"It's a noble effort," says banking consultant Bert Ely of the Group of Thirty report Global Institutions, National Supervision and Systemic Risk, "but the approach has fatal flaws. The G30 wants to marry industry self-regulation with government supervision in a manner that is unworkable.
"The operative principle will be that if institutions don't do a good job of policing themselves, the standing committee will kick them out of the club," says Ely. "That may be fine for those who remain, but those who get kicked out will still be in business." Ely expects some would become industry renegades, causing the type of problems that lead to government supervision in the first place.
Many institutions have made great strides in developing their risk management systems in the past few years but Brian Quinn, a former head of supervision at the Bank of England and a member of the G30 study team, worries that: "The people who responded to our survey expressed confidence in their own risk management and their main counterparties, but that confidence was not based on any very detailed knowledge of what their counterparties were actually doing and how they manage themselves. To a certain extent, it was an act of faith."
Tom Russo, a managing director at Lehman Brothers, thinks self-regulation on a global scale is the answer. Russo tried this approach domestically as a member of the Derivatives Policy Group, made up of America's six largest investment banks. High US government officials actively supported them. Two years ago, the DPG produced a "voluntary" framework for managing risks from over-the-counter derivatives (those not traded on a regulated exchange).
Gerald Corrigan, formerly president of the Federal Reserve Bank of New York, is candid. "There are those who have construed the G30 report as a major thrust in the direction of self-regulation per se. I don't see it that way. I think it's complementary to official regulation and can make it work more efficiently and more effectively. It would be a mistake to conclude that this in any way weakens or undermines the role of supervisory authorities. As a practical matter, there is absolutely no enforcement power whatsoever vested with the standing committee. That's why it's wrong to think of this as self-regulation."
Marshall Carter, president and CEO of State Street Bank & Trust in Boston, believes that the next step should involve the G7 or the G10 finance ministers and their deputies. This worked for the G30 in the wake of its highly successful project on clearing and settlement several years ago. Carter is a strong supporter the G30, but does not expect to serve on the proposed standing committee.
But some observers think that the official community would never need to become directly involved. They predict that few institutions would hold out if the 20, 30 or 50 major participants agreed to operate according to the standards and did so. But they assume, of course, that one of the standards would prohibit transactions with counterparties who were not in compliance.
So the pressure on individual institutions would be enormous either to observe the standards or to find operating procedures that would persuade the rest of the market that they were comparably safe. Any institution operating outside the standard would therefore have a reduced capacity to create a systemic risk, or so the argument goes.
But an influential US Congress staff member objects: "First, you're giving a small group from the private sector governmental power. Behind governmental power in the end is the use of force. However select and representative this group might be, nobody elected them to anything. This also allows government to increase regulation while pretending that it's private business regulating itself. Both of these aspects are abusive because they avoid the kind of public scrutiny that representative government requires."
And most American legislators would no doubt agree that it's very beneficial to develop international rules by consulting as much as possible with the people who must live with them. But governments start getting into trouble when they institutionalize that consultation process and give a public role to the private sector. At least one well-placed staffer believes that regulators should consult explicitly with the private sector on their own behalf, using their own staffs, at their own public hearings.
Congress had similar concerns about the Derivative Policy Group. Its recommendations are said to be voluntary, but institutions that don't follow them will be looked on very unfavourably by credit-rating agencies, investors and others. So how voluntary are they in practice?
The threat goes from the bottom up and the top down. Industry self-regulation can be used by the private sector to "capture" its regulators. Such mechanisms allow favoured businesses to increase their protected position in the marketplace. Government, meanwhile, can use industry self-regulation as a means to regulate business "implicitly".
Robert Litan, director of economic studies at the Brookings Institution and a former anti-trust official in the Clinton administration, sees the potential for anti-competitive behaviour in these terms: "If you have a body that starts to decide who's good and who's bad, then there's a question of due process. You could have an anti-trust complaint being brought by somebody who said that they got screwed because there was a kangaroo court set up to judge them. I don't think that's what the G30 is recommending. What I do see is a first step where banks get together to agree on the best way to prevent rogue traders from ripping them off, to agree on some of the best ways to model risk and so forth. Then, they can hand it over to the regulators who can figure out whether people are complying."
The basic idea in the G30 report, according to Bert Ely, "is to look to the accounting firms to save the day. The supervisors would, in effect, free ride off the principles and best practices developed by the standing committee and then apply them to everybody, including those who are reluctant to participate and find some way to evade. That puts the monkey on the back of the accounting firms."