How Should Regulators Address the Subprime Crisis?

01 May 2008

More concretely, the frequent reporting of bad news from financial institutions in the US and Europe has challenged these regulators and supervisors to re-evaluate their approach to the supervision and regulation of banks, in particular investment banks. While some politicians, as well as a significant part of the public at large, were quick to call for more and intensified regulation and supervision of investment banks, more considered voices have called for a thorough and in-depth analysis of the subprime crisis before jumping to conclusions. As Hal Scott, a Harvard finance professor, recently put it in the Financial Times, there will be huge consequences from regulatory change and the lesson learned from Sarbanes-Oxley is not to rush. Moreover, a call has been made for politicians not to rewrite history by, for instance, advocating for the reinstatement of the Glass-Steagall Act or similar regulations that would significantly restrict investment banks in their activities.

The renowned US judge, Justice Oliver Holmes, expressed in one of his famous statements the view that "great cases like hard cases make bad law" (Northern Securities Co v United States, 193 US 197, 400 (1904) (Holmes dissenting)). The more common saying derived from these words states that "bad cases make bad law". Calls for regulatory restraint at this point in time - and in particular before the current crisis in the financial markets - have been fully analysed and may be viewed to support that saying and generally deserve merit. Regulators are generally called upon now not to seek regulatory shackles but rather to strive for a better implementation of existing rules.

Looking back on the past 70 to 100 years, regulators in jurisdictions throughout the world in response to significant crises and hardship, have reacted very forcefully and rigidly, pushing the pendulum back to the other extreme. For instance, the enactment of the Glass-Steagall Act in the 1930s was a direct consequence of the stock market crash of 1929 and introduced a separation of bank types according to their business lines (commercial and investment banks). It took more than 60 years for this strict separation of types of banking business in the United States to be repealed in late 1999. Short-sighted calls from politicians and other interested parties to reintroduce the separation of investment banking from commercial banking seem to ignore that modern banking is radically different from banking in the 1930s and in particular ignore that modern financial technologies, such as those involving derivatives, securitisation and the likes, are not just the children of investment banking, but have significant importance in commercial and private banking and in offering products to retail customers. For example, in markets like Germany and Switzerland the introduction of structured products has changed private banking quite significantly, and retail banks as well as private banks are now required to offer such structured products to their customers; such products generally have their origin or will be structured in investment banks or similar highly specialised financial intermediaries. Accordingly, instead of resorting to such bold moves like the imposition of commercial bank-style rules on investment banks, regulators and supervisors should apply regulatory restraint in the first instance and demand that banks (commercial and investment banks) first analyse their risk profile and risk-management processes to understand the interrelation of the various risks associated with the financial technology as currently applied. As an example, since late 2007 a group composed of US, UK, German, French and Swiss regulators (the Senior Supervisors Group) has conducted a joint survey of major financial services firms in their jurisdictions to understand and analyse the role of senior management oversight in assessing the changing risk landscape, the effectiveness of market and credit risk-management practices and liquidity risk-management practices. Their report issued on 6 March 2008 reveals significant differences among various major financial services firms in their approach to understanding, analysing and managing market, credit and liquidity risks. The report concludes, inter alia, that there is a need to strengthen management of such risks and to improve quality and timeliness of public disclosures of financial services firms about their course of business and its impact on financial statements. In addition, the report goes on to call for revisiting the challenges in managing incentive problems created by compensation practices.

Many market participants have argued that one of the prime causes of the current financial crisis is the lack of confidence in market participants, which itself is partly caused by a significant lack of transparency. In response to that phenomenon, the International Organization of Securities Commissions (IOSCO) launched a task force on the subprime crisis in November 2007, which is, inter alia, focused on enhanced transparency by financial institutions in connection with the issuance of structured products. It was generally perceived by IOSCO that a widespread lack of knowledge of the technology used in the design of structured financial instruments and in their marketing to the primary market was one of the most significant contributors to the lack of understanding of the products themselves and their relation to other investment products. IOSCO called for financial institutions to enhance the information available to the primary markets on structured financial instruments and to cooperate with one another to achieve an appropriate level of such information in the markets. In addition, IOSCO called for an accurate and complete disclosure of the size of exposures related to structured finance to the market. Just recently it also called for an improvement in the quality and integrity of the rating process and proposed key changes in relation to the role in the rating process played by credit rating agencies. According to IOSCO, related measures should involve, among other things, the establishment of or ensuring that the decision-making processes for reviewing and potentially downgrading a rating of a structured finance product are conducted in an objective manner and the establishment of independent functions responsible for periodic reviews of a credit rating agency's rating methodologies and models. A particular focus should be laid on the assurance that credit rating agencies are and remain independent and shall avoid conflicts of interest with a view to their responsibilities to the investing public and issuers.
In the early stages of the financial crisis, many observers initially attributed the emerging problems to the hedge fund industry and their exposure to the financial industry at large. Because hedge funds operate in a largely unregulated environment, significant concerns had been raised within international organisations and bodies such as the Financial Stability Forum and IOSCO as to whether hedge funds could be the origin of systemic risks and, if so, whether they should be specifically regulated. However, probably surprising to some, little by little it became clear that the regulated financial intermediaries (in particular investment banks) not the hedge funds played the crucial role in the US credit crisis, which is spilling into many parts of the world. In line with many other country's regulators, the Swiss Federal Banking Commission concluded in its September 2007 report that, from a regulatory perspective, it would be most efficient to address any systemic risks originating from the hedge fund industry by regulating not the hedge funds themselves, but rather their counterparties, the banks, probably in a more comprehensive and intensive manner than previously. Similarly, the March 2008 report of the Senior Supervisors Group concluded that particular regulatory focus should be placed on improving and managing risk management tools and valuation models for complex and illiquid financial instruments. Against this background, it is rather surprising that recently calls have been made to restrict leverage ratios up to which hedge funds may incur indebtedness in the pursuit of their investment policies and to generally put regulatory shackles on participants in the financial markets, in particular those that design and sell complex new financial products.

Instead of taking the draconian regulatory measures advocated by some politicians and select interest groups, regulators would likely do better first to assure thorough implementation of and adherence to existing rules. Secondly, pursuing the calls for transparency made by senior regulators as well as industry bodies such as IOSCO would result in requiring all participants in the financial market to improve the transparency of business models and financial exposure. It would also require more comprehensible disclosure about particular financial technologies and instruments, as well as certain accounting policies. This might also mean that the financial industry, in particular the accounting firms, should reconsider whether the current accounting policies actually further the transmission of accurate and comprehensible information into the market and enhance transparency, or whether they create an unwieldy, difficult accounting scheme that is no longer manageable for most of the participants in the financial markets.

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Calls for some restraint on the part of regulators and supervisors in their approach to the current financial crisis seem to be merited. Regulators and supervisors should first analyse in depth the origin and causes of the crisis and then focus on the enhancement of transparency and disclosure to the market and on the improvement of risk management tools and practices, rather than bowing to pressure from politicians and interest groups, advocating the short-sighted imposition of new prohibitions or harsh restrictions on banks, in particular investment banks. Moreover, regulators and policymaking bodies around the world should reconsider the role of incentive structures in the banking industry and their impact on the management of risk within financial services firms. And finally, it probably has never been more important that supervisors throughout the world closely coordinate their policies through the appropriate bodies such as the Basel Committee on Banking Supervision, IOSCO and the Joint Forum. Any over-regulation in one part of the world would risk regulatory arbitrage - players in the global financial industry will always identify jurisdictions in which they could continue to operate without being forced to comply with tightened restrictions, new prohibitions or regulatory shackles.

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