Whither Risk & Regulation?
I attended an interesting seminar last week on regulation by FRS Global. It turned into a bit of an advert for the company's product (well, they were sponsoring it and their staff were the speakers!), but some very interesting stuff came out of it.Firstly, there is no doubt that we will have more requirement to manage risk, and can expect more regulation. The question is, will it all be better? Regulation should consist of three points of focus: assessment (where is our risk?), measurement (how much risk do we have and how much capital do we have?) and policies (how much risk and of what sort do we actually want and how much capital is needed?). It also needs to be "cycle-proof" (i.e. be capable of covering good times as well as bad). Raghuran Rajan in The Economist points out that we feel most need to regulate in times of crisis (witness Gramm-Rudmann and Sarbanes-Oxley), and this tends to result in more problems in the long run.
"Old" regulation consisted of the balance sheet ratios that we saw up until the 1980s, Risk Weighted Assets and Minimum Capital Requirements. Then along came Basel II which was meant to improve things with more sophisticated risk-weighting and taking guarantees and concentration risk into account. The shouting hasn't stopped on this...
The problem with all of this was that it was backward-looking - i.e. focusing on past performance. It was also book-value oriented, slow, expensive and inflexible. Regulators have also been accused of taking a too light touch approach in good times when things were already starting to go wrong.
The "New" regulation needs to encompass better coverage of risk exposure, the acquisition of better and higher quality capital, higher liquidity buffers, stronger risk management, more transparency of risk portfolios and stress-testing. It also needs to be enforced by regulators who are respected in markets and governments.
Interestingly, there was general agreement that we need to have more focus on system-wide supervision to include hedge funds, rating agencies and compensation for top executives as well as limiting the size of financial players. Rajan also argues for a system of capital infusion when institutions or the system are in trouble and for systemically important and leveraged firms to buy insurance (fully collateralised) to capitalise themselves when the system is in trouble.
In all, the "New" regulation has to be forward-looking and this will require comprehensive reform, but not reform that is overly burdensome and inflexible. In theory, we would have an ideal situation where there is no difference between regulation and risk management. We would have new rules which are simpler and more effectively enforced. I would also expect to see better cooperation on the international front, given the scope of the current crisis.
Will this come to pass? Who can say. There are any number of barriers, including sectoral self-interest, national self-interest and inevitably the argument of how much this will all cost to put in place. Even if it does happen, my greatest concern is that once the good times roll around again, those with wiser and more cautious heads will be ignored again as the sun shines....
Labels: Financial
posted by William Martin @ 21:38
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