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In the run-up to the World Bank/IMF meetings a year ago, it had still seemed possible that the financial industry could put its own house in order by codifying and implementing new best practices for risk management. But over the next six months the global financial system came close to outright collapse.
So now, as the meetings in Istanbul unfold, government policymakers and regulators around the world are striving to agree new rules to make the financial system safer. The level of capital in the banking system will go up. This will be high-quality capital according to definitions the Basle Committee on Banking Supervision is due to deliver before the end of this year. By the end of next year, the US Treasury wants full agreement on new international standards on capital and liquidity. Much remains to be done. Euromoney has a few recommendations.
The banking industry will assail the official sector with arguments against imposing leverage ratios, arguing that they take no account of the riskiness of assets being leveraged and might impose a burden on banks that will make them less able to lend into the economic recovery. These warnings should be discarded. Regulators should use a blunt leverage ratio as a warning signal, so that if regulated banks exceed it, they are called to account.
Banks will put up even more stern arguments against being required to ring-fence capital and funding in each country where they operate. They will raise threats of diminished funding being made available to emerging markets.
The best and brightest minds in the official sector should go to work on this question. But the burden of proof must lie with international banks to say why regulators should not follow this path. The working assumption should be that the ring-fenced capital approach will substantially reduce systemic risk while at the same time discouraging imprudent lending, which can destabilize smaller national economies, in much the same way as highly volatile capital flows.
At the same time, governments should place a higher priority on developing new cross-border approaches to the resolution of insolvent financial institutions. These are now subject to study in the depths of various IMF, World Bank and Basle committees. Governments should be working urgently towards a binding agreement or treaty on burden sharing in such circumstances. Achieving this, along with the implementation of the ring-fenced capital model, will allow regulators and governments to relax other suggested requirements.
It should remove any need to impose additional capital requirements on international banks simply because of their size and perceived contribution to systemic vulnerability.
Politicians need to be grown-up with their electorates on the subject of bankers’ pay. It is not the role of governments to pass laws to cap it. Banks should provide guidance on the proportion of compensation – both fixed and earnings-related – they pay out of operating profits. In that way, both shareholders and regulators can assess the risks that banks are taking, and the former can judge whether the institution is being run principally for the benefit of investors or employees. Staggered payments and clawbacks on bonus pools are established and must become ubiquitous.
Shareholders should become more active in influencing the strategies and behaviour of bank boards. But bank leaders must understand that, in a world where few investment institutions can carry much clout individually or collectively, it is incumbent upon them to appoint independent, non-executive directors whose experience enables them to represent the interests of stakeholders, and stakeholders only.
Upholders of accounting standards must be subject to oversight and accountability similar to that being called down on bankers and ratings agencies. They need to allow provisioning against expected losses and come to an agreed approach on mark-to-market accounting that goes beyond its mere suspension when markets become inactive and disorderly.
Behind the recent near-collapse of the banking system lay a 15-year transformation of the extension of credit into a traded market. The notion of setting an initial margin on five-year loans sufficient to last through the economic cycle gave way to high-velocity trading. Policymakers should give serious consideration as to the benefits and costs of all this and should weigh redefining credit default swaps as insurance policies that can only be taken out by a party that has an underlying insurable exposure.
Most important of all, before the new capital rules are agreed, let alone implemented, some credible and capable body – or perhaps the IMF – must conduct a full study of what they will do to the cost and scale of bank lending.
It is an astonishing and troubling oversight that this has not yet been begun. Regulatory failure was as big a contributor as bankers’ and investors’ greed to the recent collapse. Let’s not compound old errors with new.
