09 December 2009

“In Praise of Unlevel Playing Fields” Regulatory Commission Recommends New Slant on Solving Financial Instability

In a pathbreaking report on reforming the international financial system in the wake of the global crisis, an international commission makes five key recommendations that they believe will enhance financial stability.

Parting company with the traditional view that regulation should be even handed for all institutions and countries, the Report of the Warwick Commission, an international body of leading academics and market practitioners, argues that there is a need for an ‘unlevel playing field’ in order to offset the tendency towards unstable behaviour in the global financial system.

A key recommendation is that in times of economic and financial boom, banks and financial institutions need to have their ability to create loans reined in, in order to avoid fuelling asset market bubbles.

Second, the Commissioners argue that financial regulators need to curtail institutions’ ability to heighten risk by mismatching the maturity of their assets and liabilities and in particular their tendency to borrow short-term against highly illiquid collateral during asset market booms.

Third, regulators must have the flexibility to apply tight regulatory requirements on institutions that threaten the stability of the whole financial system.

Fourth, going against the tide of increasing global financial regulation, the Commission argues for increased powers for national regulators in a bid to prevent banks from establishing overseas branches and regulating them from their home base. Under the host country rules recommended by the Commission, banks would have to establish an overseas subsidiary that is regulated by the local regulator.

Fifth, the Commission argues that host regulation would lead to a ‘right-sizing’ of the financial sector, so that the finance industry is not allowed to excessively dominate a country’s economy or harm national welfare systems, and the Commission suggests a system of regulatory measures to help achieve this.

The Commission was chaired by financier Avinash Persaud and was an initiative of the University of Warwick, one of the UK’s top universities. It comprised twelve commissioners drawn from universities and research institutions across Europe, North America and Asia, who met in Warwick, Berlin and Ottawa over eight months in 2009 in order to develop its recommendations, taking oral and written evidence from financiers, civil servants and academics in London, Paris, Brussels, New York and Washington.

The Report has been welcomed by a number of key policy makers.

Commenting on the Report, Adair Turner, Chair of the UK Financial Services Authority, said:

On all the issues it addresses, [the Warwick Commission] is able to challenge conventional wisdoms, free from the constraints which inevitably influence the thinking of official authorities involved in complex international discussions... Its focus on the credit cycle as the key driver of financial and macro-economic instability is correct and crucial...

Andrew Sheng, Chief Advisor to the China Banking Regulatory Commission, commented:

The Warwick Commission is to be congratulated on taking a fresh look at the challenges facing international financial reform. The current global financial crisis demonstrated unequivocally that the world is unbalanced and will always be in a state of constant change. For this reason, the Warwick Commission tries to challenge the orthodoxy and should be congratulated for its recommendations and
suggestions for understanding that there is no self-equilibrating stability, but a dynamic evolution where we need to encourage diversity of thinking to get more balanced markets than uniform thinking that herds into one direction.


Mark Carney, Governor of the Bank of Canada, writes:

Refusing to treat the recent crisis as a special case, it examines the
causes of financial crises in general. With its sophisticated grasp of how the credit cycle operates, innovative reform proposals, and considered treatment of the political economy of regulation, the Report should prove invaluable to policy-makers at this critical juncture.


The Warwick Commission on International Financial Reform: In Praise of Unlevel Playing Fields

Executive Summary and Recommendations

This is not the first international financial crisis the world has seen. This tells us two things. First, in trying to prevent or dampen future crises, we must not focus too heavily on the specific character of the present crisis. We must focus on those factors that are common across financial crises. There will be a different financial innovation or product at the centre of the next crisis. Second, it is unhelpful to think in terms of increasing or decreasing the quantity of regulation. There is good and bad regulation. If elements of the current approach to regulation incentivised systemically dangerous behaviour, doubling up on existing regulation or spreading it more widely may make matters worse. While we doubt that financial crises can be prevented, we do believe strongly that policymakers, regulators and supervisors have the power to make them less frequent, shallower and with less spill over onto the welfare of ordinary households. The purpose of this report is to set out the regulatory approach that will help them do so across a variety of countries.

Large international banks have promoted the idea of a level playing field in regulation between countries (home country regulation) and within countries (unitary regulators and an end to ‘Glass-Steagall’ type segmentation of financial sectors). It seems heretical to argue against ‘level playing fields’, but in certain areas of finance, an unlevel playing field has merit. We need an unlevel playing field between countries as a result of the policy responses to economic cycles that are often less synchronised than they appear. We need to tilt the playing field within countries to reflect the unlevel capacity of financial institutions for different types of risk and to help risks flow to where they are best matched by risk capacity. We need a financial system that is robust to shocks, and that requires diversity, not homogenous behaviour derived from the blanket application of the same rules and standards on valuation, risk and trading. An unlevel playing field between countries is also desirable so as to best take into account different national political priorities, financial structures and institutional capacities.

The Commission recommends the following five key policy reforms in the Report:
  1. Regulation needs to be formally more countercyclical, to offset the endogeneity of risk that arises from the credit cycle. Capital requirements, leverage ratios, maximum loan-to-value ratios must be tightened in the boom and loosened in the crash within a rule-based framework.
  2. Risk-taking must be matched to risk capacity for the financial system to be resilient. One way to achieve this is through capital requirements for maturity mismatches (administered in a manner to avoid procyclicality).
  3. Regulators must have the flexibility to apply tighter regulatory requirements on systemic institutions, instruments and markets. Regular system-wide stress tests should help to identify what is systemic.
  4. Greater emphasis must be placed on host country regulation within a more legitimate system of international cooperation. Host country regulators must be able to require foreign and domestic banks alike to keep local capital against local risks. Accountable global institutions should coordinate host country regulations, share information and lessons in order to improve regulatory effectiveness and limit regulatory arbitrage, and regulate market infrastructure for global markets such as single clearing and settlement houses. They should also be engaged in capacity building for countries with less developed financial systems.
  5. Incentives for the financial sector and for financial firms to grow in size and influence, and to concentrate on short-term activity, must be offset, perhaps through additional capital requirements for large institutions.

Download the Full Report

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