The Concept of Financial Regulation and Its Scope - Assignment Example

International Financial Law: Critically Discuss the Concept of Financial Regulation and its Scope. Introduction The global financial crisis that began in 2007 drew attention to the appropriate goals of financial regulation and the best regulatory methods for meeting those objectives.1 The global financial crisis that began in 2007 however is just the latest in a long history of banking crises since the 1970s. The 1970s is an important era for conceptualizing the development of financial regulations as it was in 1974 that the Basel Committee on Banking Supervision was formed for supervising international banking institutions.2 According to Currie, there have been at least 117 banking crises in 93 countries since the 1970s.3 Much of the blame is attributed to an international banking regulatory system that was primarily ad hoc in nature that simply responded to each crisis. However, the primary theme of international financial regulation was based on establishing minimum capital requirements.4 The widespread nature of the systematic failure of banks and financial institutions worldwide in the most recent global financial crisis has drawn attention to a need to reconceptualise the appropriate regulatory framework for the international banking and financial systems.5 This paper provides a critical analysis of the concept of financial regulation and traces its evolutionary development. This paper is therefore divided into two main parts. The first part of this paper provides a brief overview of the concept of financial regulation prior to the global financial crisis and the second part of this paper critically analyses the concept of financial regulation as informed by the global financial crisis of 2007. The Concept of Financial Regulation Prior to the Global Financial Crisis of 2007 Basel and International Financial Regulation According to the International Monetary Fund (IMF) financial regulation in the decades prior to the global financial crisis of 2007 differed from one country to another.6 A common them was regulation and supervision to ensure capital liquidity.7 The concept of international banking regulation was indeed focused on capital liquidity as the primary method of financial regulation as evidenced by the founding and development of Basel. Basel was established by G10 which were a group of representatives from central banks and national banks and was referred to as the Basel Committee on Banking Supervision.8 The 1975 Basel Concordat formally established and distributed responsibilities for supervising international banks following which the Basel Capital Adequacy Accord was established in 1988 (Basel 1) defining minimum capital requirements for international banks. From 1998 to 2004 Basel II reset the minimum capital requirements. The regulatory mandate of Basel also established the International Organization of Security Commission in 1983 to extend Basel’s regulatory mandate over other non-banking institutions in the global financial market.9 In 1994 the global insurance market was added to Basel’s international financial regulatory regime. Meanwhile in 1990, Basel’s G10 members extended its capital regulatory and supervisory mandate by establishing the Committee on Payment and Settlement Systems (CPSS) setting forth standards for payment systems and for settling securities.10 The Concept of Financial Regulation as Articulated by Basel Essentially the concept of financial regulation as expressed by Basel I was one that envisioned that financial risks could be tempered by merely ensuring capital liquidity. Therefore Basel I established a minimum capital requirement. However, as Saurina informs, Basel I’s minimum capital requirements were “not sensitive to risks”.11 As Saurin informs: A loan to a nonfinancial firm required 8 percent of capital, irrespective of the firm’s risk (that is, its leverage, profits, solvency, and economic environment). This ran counter to the way banks managed their loan portfolios and economic capital (considering far more sophisticated measures of risk).12 It therefore makes sense that when Basel II was implemented it gave expression to a new concept of banking regulations. At this time, it was perceived that establishing mere capital requirements was insufficient to achieve the main purpose of financial regulation: risks must be tempered. Basel II sought to respond to banking risks by updating the capital requirement and establishing pillars by which international banks should consider regulating finance. By virtue of Pillar I, banks are required to assess a borrower’s ability to satisfy a loan or credit facilities even during an economic downturn.13 Again Pillar I can be interpreted to be a round-about method of conceptualizing financial regulation as controlling capital liquidity. Many potential qualified borrowers will be unlikely to repay a load during an economic downturn, thus Pillar I significantly reduces the number of persons who would qualify for a loan or credit facilities and thus ensuring that banks would reduce the risk of liquidity shortfalls. Pillar II of Basel II again speaks directly to capital control by requiring banks to take account of business cycles when evaluating their respective bank’s “capital adequacy”.14 The difficulty with both Pillars I and II is that banks do not usually maintain the minimum capital requirement as they typically rely on loans together with “new business opportunities” and other financial services for raising capital.15 Pillar III mandates “bank risk transparency toward investors”, making it “more difficult for bank managers to reduce capital levels”. 16 Despite the fact that Basel II is more sensitive to risks than Basel I was, Basel II nevertheless focused on regulating capital and ensuring capital adequacy emphasising methods for ensuring that banks met the minimum capital requirements. However, as Saurina noted: The behavior of credit may depend on demand factors unrelated to banks’ capital or many be determined by supply factors not directly related to the level of banks’ capital buffers.17 In other words, capital liquidity alone cannot mitigate other risks that do may occur independent of capital adequacy. For example, a burrower may have the ability to satisfy a loan during an economic downturn, or for whatever reason may simply refuse to repay the loan. This kind of risk is not eliminated simple because the bank maintains the minimum capital requirements. Moreover, a bank may have the minimum capital requirement, but systematic failure by another bank may nonetheless create a crisis in the bank maintaining a minimum capital requirement. In addition, a bank may find it necessary to reduce it minimum capital requirement for the purpose of raising funds to avert a crisis. It therefore follows that financial regulations were conceptualized as processes and systems designed to safeguard against banks’ liquidity falling. This is hardly surprising since the G10 group establishing Basel were primarily central bank officials from around the world. As Copelovitch and Singer inform, central banks typically implement their respective state’s: Monetary policy by controlling the money supply and setting interest rates based on current economic conditions. In addition, some – but not all –central banks serve as bank regulators with responsibility for implementing rules and restrictions on banking activities, supervising compliance with prudential regulation and applicable laws, and otherwise safeguarding the stability of the banking sector.18 Since central banks are typically empowered and quite often required to rescue failing banks when they are in danger of failing or have failed, it is hardly surprising that central banks want to use their best endeavours to ensure that banks maintain a certain amount of capital. However, this conceptualization of banking regulation merely took account of the result that should be accomplished if banks were regulated and supervised to be efficient in managing risks and therefore having acceptable balance sheets. In fact, Cebenoyan and Strahan argue that banks that efficiently manage capital risks will have greater flexibility and will be able to extend loans to borrowers who would otherwise be a risk.19 The Cebenoyan and Strahan express a concept that banking regulation should be more about managing risks as opposed to the reduction of risks via capital control and capital liquidity. The Concept of Financial Regulation following the 2007 Global Financial Crisis Informed by the problems attributed to the global financial crisis of 2007, the HM Treasury reported to the UK Parliament that an effective financial regulatory framework would be one that identifies “problems” that are “building up in the financial system”.20 An effective financial regulatory system is also one that takes the necessary steps for mitigating those risks and problems to avoid those problems creating “instability in financial markets” and to have safeguards in place for adequately dealing with a crisis in the event a crisis does in fact occur.21 The HM Treasury’s concept of financial regulation is therefore one that views financial and market stability as much more than simply maintaining capital stability, but also about managing risks to financial and market stability. In the aftermath of the global financial crisis, the concept of financial regulation has changed from capital intensive regulation to taking account of: A cluster of interrelated policies designed to ensure the proper functioning and integrity of financial systems.22 Obviously, capital regulation remains an important factor, but a focus on capital requirements has proven to be inadequate for conceptualizing financial regulation. As Vernon argues, rather than simply regulating bank capital, it should be both regulated and supervised instead. In addition, the concept of financial regulation should be the regulation and supervision of: ...Leverage, liquidity, and risk management; control of moral hazard and financial industry incentives; protection of the customers of financial services; and the regulation of capital markets.23 Thus a new concept of financial regulation emerged in the aftermath of the global financial crisis of 2007. This new concept was more specifically articulated by the G20 group of states representing leaders from around the world who sought to understand the causes of the global financial crisis and the appropriate responses to it.24 In setting out its core principles for financial market reform, the G20 articulated financial regulation as founded on concepts that focus on corporate governance. The five core principles of reform can be summarized as follows: Enhancing accountability and transparency; Implementing “sound regulation”;25 Ensuring that the financial markets can be trusted. Improving cooperation at the international level; and Improving international financial institutions via reform.26 Two significant departures from the previous concept of financial regulation can therefore be observed. Previously, financial regulation was perceived as regulating the minimum capital requirements of banks and focusing on identifying risky clients by ensuring that they were credit-worthy and therefore risky. The five core principles articulated by the G20 group of state leaders emphasized instead, a need to focus on the risky behaviour of banks by monitoring their decisions and methodologies. Minimum capital requirements are not one of the five core principles of the G20’s concept of financial regulation. Arguably, risk management by virtue of corporate governance models should naturally ensure that banks achieved capital liquidity. Basel’s financial regulatory concept erroneously took the position that capital adequacy would ensure good corporate governance while the G20 group of state leaders took the position that good corporate governance would ensure capital adequacy. The capital intensive financial regulatory system proved to be an inadequate way of conceptualizing financial regulation. The 2007 global financial crisis demonstrated that banks do not operate in a vacuum. Banks are the oil that stimulates the economy and when banks fail, the economy suffers. Banks not only lend money to individual consumers, but also to businesses. Thus when banks failed during the global financial crisis, there was a general feeling of panic and mistrust among consumers, which only served to exacerbate the crisis.27 Therefore, the global financial crisis of 2007 revealed that the international financial markets have changed and concepts of financial regulation must change to correspond with the changes in the financial market. As Davies and Green point out, the financial markets in the global economy are not intricately connected. Davies and Green point out that: New instruments have emerged which make it possible to transfer risk of all kinds on a far larger scale and in more complex ways, not solely through standardized exchange-traded derivatives, but through an almost infinite range of bespoke, over-the counter arrangements...While these instruments make it possible to lay off risk over a vastly greater range of risk bearers...they also mean that when risks crystallize they may well have an impact in hitherto unfamiliar place, anywhere in the globe.28 In this regard, financial regulation is conceptualized as whole system control and interagency cooperation for due diligence and risk management. The difficulty with financial regulation reform is the overlapping concept informed by past experiences that financial regulation is a means by which banks are reined in to avoid instability in the banking sector and thus the real economy. It has always been a central tenet of regulators that tightening capital controls over banks was the best method for reining banks in. At the same time, the number of banks appearing on the global financial market indicates that tight capital controls would render banks unable to compete on the global financial markets.29 As a result the concept of financial regulation is becoming more complex in that the underlying gaol of providing safe and sound financial systems and protecting the interests of investors and consumers must be reconceptualised given the growing complexities of the global financial markets.30 While liquid assets are associated with stability, financial regulatory systems that dictate a minimum capital requirement as the core principle of financial regulation, it does not address the complex nature of risk in a highly globalized financial market. Researchers have been calling up regulators to take a more active role in ensuring that financial institutions, including banks, adopt the best practices and policies possible and become “more accountable and efficient.”31 In the reconceptualising of financial regulation following the global financial crisis of 2007, there is an increased realization that: A mismanaged bank may lead to a bank run or collapse, which can cause the bank to fail on its various counterparty obligations to other financial institutions and in providing liquidity to other sectors of the economy.32 Thus financial institutions are required to strike a fair balance between shareholders of their respective financial institutions and a broader class of stakeholders including actual investors and the real economy as a whole. Therefore regulators will typically provide detailed rules and regulations which influence the decisions and actions that key management in financial systems make in the day to day running of a financial institution.33 In this regard, concepts of financial regulation are entirely important as it informs the decisions, judgements and activities of financial institutions. For example, Basel II’s requirement that banks take account of a borrower’s ability to satisfy a loan even in a particularly adverse economy, will basically deprive a bank of flexibility in determining who to advance lines of credit to even if the bank may have preferred to take the risk since an adverse economy may not be a threat at the time the borrower applies for credit. The approach taken by regulators indicate that financial regulation is conceptualized as a tool for safeguarding the interest of the wider public as opposed to the interest of the bank. Therefore de Andres and Vallelado advise that special boards consisting of shareholders and their proxies should be more actively involved in the corporate governance and regulation of financial institutions.34 However, this may be an undesirable approach as it may feed into the mistrust the accompanied the global financial crisis of 2007. Banks need the support and patronage of members of the general public to survive. Therefore, if a bank’s regulatory regime is dealt with internally, members of the public will likely perceive that banks are above the law. Members of the public conceptualize financial regulation as a means of ensuring that banks do not take risks that compromise their investments in the bank. Moreover, the appointment of regulators indicates that accountability and some degree of transparency. Conclusion The concept of financial regulation both before and after the global financial crisis of 2007 was predicated on single goal: stability in international financial markets. The only difference in these concepts is the methodology for regulating for this outcome. Prior to the global financial crisis, the common methodology for achieving stability in international was to emphasize capital adequacy. This was achieved for the most part by establishing a minimum capital requirement. This approach to financial regulation proved inadequate as evidenced by the financial crises occurring over the years and culminating in the most recent global financial crisis. In the aftermath of the global financial crisis, concepts of financial regulation have been modified to take account of the complexities created by virtue of globalization. Banks and financial institutions as a whole are called upon to be more vigilant and in doing so preserve the integrity of banks. Banks are also called upon to be more transparent and accountable. While capital adequacy continues to be a part of the regulatory process, the emphasis is now on how banks manage risks rather than how they reduce risks. It can therefore be concluded that the emerging concept of financial regulation is now more about risk management through standardized practices than on risk reduction through capital requirments. Bibliography Textbooks Davies, Howard and Green, David. Global Financial Regulation. (Cambridge, UK: Polity Press, 2008). Journal Articles Cebenoyan, A. Sinan and Strahan, Philip, E. ‘Risk Management, Capital Structure and Lending at Banks.’ (2004) 28 Journal of Banking & Finance, 19-43. Copelovitch, Mark, S. and Singer, David Andrew. ‘Financial Regulation, Monetary Policy, and Inflation in the Industrialized World,’ (July 2008) 70(3) The Journal of Politics,’ 663-680. Currie, Carolyn. ‘A New Theory of Financial Regulation: Predicting, Measuring and Preventing Financial Crises.’ (2006) 35 The Journal of Socio-Economics, 48-71. Helleiner, Eric and Pagliari, Stefano. ‘Crisis and the Reform of International Financial Regulation.’ In Eric Helleiner, Stefano Pagliari, and Hubert Zimmermann (Eds.), Global Finance in Crisis: The Politics of International Regulatory Change. (London: Routledge, 2009). Alexander, Kern.‘Corporate Governance and Banks: The Role of Regulation in Reducing the Principal-Agent Problem.’ (2006) 7 Journal of Banking Regulation,17-40. Morris, Stephen and Shin, Hyun Song. ‘Financial Regulation in a System Context.’ (Fall 2008) Brookings Papers on Economic Activity, 229-274. Norton, Joseph, J. ‘The Santiago Principles for Sovereign Wealth Funds: A Case Study on International Financial Standard-Setting Processes.’ In Thomas Cottier, John H. Jackson and Rosa M. Lastra, (Eds.) International Law in Financial and Monetary Affairs. (Oxford, UK: Oxford University Press, 2012). de Andres, Pable and Vallelado, Eleuterio. ‘Corporate Governance in Banking: The Role of the Board of Directors.’ (December 2008) 32(12) Journal of Banking & Finance, 2570-2580. Saurina, Jesus. ‘Banking on the Right Path,’ (June 2008) Finance & Development, 30-31. Sikorski, Douglas. ‘Initial Causes and Effects of Financial Turmoil.’ in Johathan A. Batten and Peter G. Szliagyi (Eds.) The Impact of the Global Financial Crisis on Emerging Economies, (Bingley, UK: Emerald Group Publishing Limited, 2011). Singer, David Andrew. ‘Uncertain Leadership: The US Regulatory Response to the Global Financial Crisis.’ In Eric Helleiner and Stefano Pagliari, (Eds.). Global Finance in Crisis: The Politics of International Change. (Oxon: Routledge, 2010). Veron, Nicolas. ‘Financial Reform After the Crisis: An Early Assessment.’ (January 2012) Bruegel Working Paper 2012/01: 1-16. Official Papers/Reports HM Treasury. ‘A New Approach to Financial Regulation: Judgement, Focus and Stability.’ (July 2010) Presented to Parliament by Command of Her Majesty, CM 7874. Merrouche, Ouarda and Nier, Erlend.‘What Caused the Global Financial Crisis – Evidence on the Drivers of Financial Imbalances 1999-2007’. (2010) IMF Working Paper, WP/10/265, 1-64. Statutes Read More