regulatory arbitrage: swirling in the eye of the storm (international finance magazine) | ron...

8/8/2019 Regulatory Arbitrage: Swirling In The Eye Of The Storm (International Finance Magazine) | Ron Nechemia

1/6


2/6

International Financing

2 0 0 9 J U L Y 35

The global financial crisis, which originated in the United States, still continues to plague

the worlds economy. Many issues surrounding this crisis such as where it came from and how

will our markets be restored also remain at the forefront of the attention In the May of 2008,

the chairman of Board of Director and permanent representative to United Nation, Mr.

Nechemia accepted the interview with the International Financing Magazine, during the

interview, he predicated with remarkable accuracy the devastating financial circumstances that

would overcome and nearly cripple the United States economy, and by extension ripple

throughout the worlds economy. Continuing to monitor global financial events, six months

later, in November of 08, Mr. Nechemia was interviewed again and featured him for Febru-

ary cover story regarding his observations about the current global economic crises and its

impact on Globals economy and on the China. In the May of 09, IFM gave Mr.Nechemia

with the third interview on the roots that the global financial crisis erupted , he pointed out that

the lack of regulatory oversight and imprudence in governance gave rise to what he and other

industry experts call , regulatory arbitrage , that greatly contribute to the global financial crisis.He also urged that with the 80-year old the worlds regulatory system with localization has

not been in conformity to development of the current global economic integration; it will leave

the more serious hidden trouble than current global financial crisis if we only focus on the

remedy of the old regulatory system, but not make a thoroughly reform on it.

egulatory arbitrage: Swirling in the eye of the StormR

Mr. Nechemia: The world economy isfacing its most difficult situation in years,against the backdrop of a deepeningfinancial crisis that originated in maturemarkets. Advanced economies areslowing markedly and some are alreadyin deep recession. The slowdown hasbeen greatest in the advanced economies,particularly in the United States, wherethe housing market correction continuesto exacerbate financial stress. Among theother advanced economies, growth in

Western Europe has also decelerated.The emerging and developing economieshave been greatly affected by financialmarket developments which crippledtheir growth. The continued strainedfinancial conditions will continue todampen global growth prospects.

The financial shock that erupted inAugust 2007, as the U.S. subprimemortgage market was derailed by thereversal of the housing boom, thenegative impact has spread quickly and

IFM: Can you provide us with anoverview of the world economy

and insight as to the conditions ofour global financial system?

unpredictably inflicting extensivedamage on markets and in many cases,

casualties upon institutions at the core ofthe financial system.

The fallout has weakened capitaladequacy at major banks, and promptedthe repricing of risk across a broad rangeof instruments. Liquidity remainsseriously impaired despite aggressiveresponses by major central banks, whileconcern about credit risks has intensifiedand extended far beyond the subprimemortgage sector. Equity prices have alsoretreated as signs of economic weaknesshave intensified, and equity and currencymarkets have remained extremely

volatile.

As we entered 2009, global financialinstitutions and markets have been badlyshaken. Threats to systemic stabilitybecame manifest in September 2008 withthe collapse or near-collapse of severalkey institutions. The far-reaching natureof the events that are unfolding isillustrated by the fact that within a periodof only one week, large stand-aloneinvestment banks disappeared from theU.S. financial landscape.


3/6

2 0 0 9 J U L Y36

FORUM

IFM: The collapse or near-collapse of several key institu-tions leads to a call for reform ofthe international financial archi-tecture and many countries

around the world are reconsider-ing the institutional structure ofregulatory and supervisory agen-cies in the financial sector; can you elaborate on the reformneeded and what are the issuesthe reform should be addressing?Mr. Nechemia: I urge that is required,what is paramount is a call for a revised,reinvigorated global governance. Thecollapse or near-collapse of several keyinstitutions, the rapid fall in value ofhousing, stock markets and assets around

the world, along with a global creditcrunch has unleashed a torrent of propos-als for reinforcing or re-structuringglobal economic and financial systemgovernance. The governance of theglobal economy and financial system isin fact quite limited mostly to standardsetting, surveillance, advice and provi-sion of capital. There is no formal group-ing of the institutions that carry it out.

Around the world, many countries arereconsidering the institutional structureof regulatory and supervisory agencies inthe financial sector. This reconsideration

reflects the concern that the existingstructures which were often estab-lished in a significantly different marketand institutional environment than existstoday may have become inappropriateto meet the key regulatory objectiveseffectively in the 21st Century. Theseobjectives include fostering marketefficiency and promoting market confi-dence and stability. As countries reassessand then implement changes in theirregulatory and supervisory architecture, anumber of issues are raised in relation toboth the developmental and stabilityaspects of the financial sectors evolu-tion.

From the developmental perspective, themain question that arises is whether theexisting organizational structure of thefinancial regulatory and supervisoryfunction is adequate to oversee an oftenrapidly evolving financial sector that ischaracterized by new types of financialinstitutions and new institutionalstructure (such as financial conglomer-ates.)

It is also feasible that a poorly structuredsupervisory function could impede finan-cial innovation or encourage inappropri-ate forms of innovation. For instance, ifthe structure gives rise to significantsupervisory gapsthat is, differences in

regulation of activities that have a similarfunction but that are performed by differ-ent institutional typesmarket partici-pants are likely to seek opportunities forregulatory arbitrage and to engage infinancial operations that are not appropri-ate from a regulatory perspective.

This regulatory arbitrage over the pasttwo decades lead to a developmentaloutcome for the financial sector that issuboptimal from the stability perspec-tive; several key issues pertain to theinstitutional structure of regulation. Thefirst concerns the question of regulatory

gaps and the implications for regulatoryarbitrage. Unsupervised, or inadequatelysupervised, institutions have been theprimary cause of financial instability. Asclear and compelling evidence, simplylook to the events leading up to, and thenfollowing when the tip of the financialiceberg emerged in August 2007; thiswas the first public glimmer that the U.S.subprime mortgage market was derailedby the reversal of the housing boom. Inthis instance, in hindsight it is clear that

Mr. Nechemia: Well, first and foremost,one of the most significant occurrenceswas the evolution of Shadow Bankingwithin the global capital markets. Untilthe early 1980s, national financialsystems were bank dominated, relatively

tightly regulated, and with limitedinternational exposures. Starting with themodest issuance of eurobonds duringthat decade, cross-border financial flowsand linkages started to expand dramati-cally. And although the 1980s debt crisesarrested the integration of developingcountries and the 1990s financial crisisseverely hurt some emerging markets,these crises had little impact on theevolution and expansion of global finan-cial markets.

the weak institutions had sought out thelines of least supervisory resistance,engaging in overly risky types of finan-cial behavior.

IFM: What are the global trendsthat led to the rapid evolution ininternational banking and thedevelopment of global financialmarkets that you believe contrib-uted to the regulatory failures ofthe systemically important finan-cial institutions?


4/6

IFM: Industry experts, such asyourself, have also said it has beenthe mismanagement of bankingand inadequate global financialarchitecture that led to the crisis.

However, your assessment of theproblem goes further, and includesa seemingly critical historicaldiscussion about the innovationin the delivery of financialservices and a remarkably absentregulatory oversight that is theroot cause of the current problem,can you explain this?

Mr. Nechemia: To make a comparison,the innovation in the delivery of financialservices is similar to what mass-production techniques did to manufac-turing a century ago. Spurred by compe-tition and investor demand, large finan-cial firms have harnessed the power ofinformation technology, marryingcomplex modeling techniques andinnovative legal structures to generate agrowing array of securities with diverserisk profiles. Consumer credit scoringhas allowed automated approval ofhousing, consumer, and student loanswhich, along with more-heterogeneousbusiness and commercial real estateloans, are increasingly bundled togetheras securities (Federal Deposit InsuranceCorporation (FDIC), 2006). Waves of

securitization, flowing from one assetclass to the next, have created newopportunities andas we shalldiscussnew challenges.

Reflecting the technological changes,special purpose vehicles are among thefastest growing holders of financialassets.

The rapid evolution of the U.S. finan-cial sector is creating new challengesfor the regulatory structure.With large financial institutions increas-ingly distributing loans to investorsrather than holding them, the share offinancial sector assets owned by insureddepositories which, along with a fewlarge investment banks, form the focus ofU.S. prudential supervisionhas fallenfrom around half in 1980 to underone-quarter in 2006. Thus, in a periodduring which the complexity of instru-ments and trades has multiplied, theportal through which the Federal Reserveviews and influences financial marketson a day-to-day basis has, in one respect,halved in size. However, it is suggestedhere that parsimony in the application ofsafety-and-soundness oversight has been

a key factor supporting innovation in theU.S. financial system.


2 0 0 9 J U L Y 37

IFM: Who has the responsibility foroversight of global financial mar-kets and more particularly theresponsibility for oversight of theUS financial markets? And in arelated question, why is there agap between the scope of regula-tion and the activities of financialinstitutions and markets?

Mr. Nechemia: The oversight of globalfinancial markets evolved over time,reflecting changes in international finan-cial markets, but the gap has continued togrow between the scope of regulation andthe activities of financial markets. TheBank for International Settlements (BIS),established in 1930, is the central and theoldest focal point for coordination ofglobal governance arrangements.

The International Organization ofSecurities Commissions, which is notlinked to the Bank for InternationalSettlements, has 109 members and covers90 percent of the global securities

markets. Another important body, the International Accounting StandardBoard, has oversight of formulation andagreement on international accountingstandards.

Also referred to as asset backed security(ABS) pools, these pass-throughstructures serve as obligors, issuingdebt backed by cash flows on the assetsthat they own. With those assets enjoyinglegal safe-harbor from any previous

owners bankruptcy, the creditworthinessof each ABS issued is a function of two,and only two, factors: the quality of theassets in the pool, and the capitalstructure (Moodys Investors Service,2007, and Standard & Poors, 2007a,b).

Led by the rapid growth in internationalbanking, global financial markets contin-ued to boomfrom just $0.1 trillion in1970 to $6.3 trillion in 1990 and to amassive $31.8 trillion in 2007. This wasaccompanied by a consolidation of theinternational banking industry a resultof a wave of cross-border mergers andacquisitions. Banks entered areas ofactivity that had previously been thepreserve of nonbank institutions (such asunderwriting, asset management, invest-ment banking, and proprietary trading),blurring distinctions between banks andother financial institutions and leading toa "shadow banking" system with largesegments of bank activity outside theperimeters of regulation. And rapidgrowth of complex securitized products,such as credit derivatives, sharply

increased banks' leverage and maskedunderlying risks. The credit derivativemarketwhich was insignificant in2001grew to about $50 trillion by2007.

The scale of relevant activities outside theregulatory perimeter depends on thedefinition of regulation. For the UnitedStates, it has been estimated that the totalassets of the shadow bankingsystemi.e., bank-like entities notsubject to bank-like prudential regula-tion were roughly US$10 trillion in late2007, about the same size as those of the

banking system. However, it is importantto recognize that this total includes theassets of entities such as investmentbanks, which were subject to a degree ofregulation, although this was oftenfocused mainly on ensuring investorprotection and appropriate businessconduct.


5/6

IFM: The growing consensus onregulatory weaknesses has led tomany reform proposals fromdifferent quarters. Can you offerus your productive suggestion on

the reform ? And what is the chal-lenge and the common theme that proposed to restore prudentialregulation that is countercyclical?

Mr. Nechemia: The crisis has revealedimportant flaws in the current globalfinancial architecture. A foundationalstarting point for reform might considerthe following as a blueprint to implementthe necessary, or rather, mandatorychanges in order to repair this systemi-cally broken system. This policy recom-mendation focuses on four key areaswhere reform is badly needed; they are as

follows:

Surveillance of systemic risk.Vulnerabilities can arise from a variety ofsources, including unexpected events,bad policies, misaligned exchange rates,credit-fueled asset booms, externalimbalances, or data deficiencies thatobscure trends. To gain traction, surveil-lance needs to be reoriented to ensurewarnings are clear, to successfullyconnect the dots, and to provide practicaladvice to policy makers.

2 0 0 9 J U L Y38

FORUM

This cuts to the arrangements that governcollective policy decisions, involvingforums such as the InternationalMonetary and Financial Committee, theFinancial Stability Forum, and thevarious Gs (in particular, the G7 andG20). Systemic concerns about theinternational economy should bereported directly to policy makers withthe ability and mandate to take action.

Cross-border arrangements for finan-cial regulation.Best practices should be developed to

help avoid regulatory arbitrage and assistin burden sharing across jurisdictions byinternational financial conglomerates,with understandings on regulation,supervision, and resolution. Theseground rules need to be strengthened andmade more automatic to avoid a repeti-tion of the go-it-alone responses seenin this crisis.

International coordination of macro-

prudential responses to systemic risk.

Funding for liquidity support or exter-nal adjustment.Public funds should be made availablefrom the International Monetary Fund,the World Bank and others to helpcountries weather short-term liquiditystrains, or to smooth necessary adjust-ments from unsustainable external trajec-tories. Given the size of internationaltransactions, these resources should beaugmented, and processes for providingshort-term liquidity better defined.

The U.S. oversight structure includesfive independent federal regulators ofdepositories(Government Accountability Office(GAO), 2004):

The Fed, founded in 1913, is umbrellasupervisor of financial holding compa-nies (some 650 of them), lead supervi-sor of BHCs (5,129), and joint primarysupervisor of state banks that are Fedmembers (892) along with the states.

The FDIC, created in 1933, is jointprimary supervisor of state nonmemberbanks (4,783 including ILCs) and statethrifts (433), back-up supervisor of allother banksand thrifts, and insurer ofall banks and thrifts (includingbranches of foreign banks).

The Office of the Comptroller of theCurrency, established in 1863 as afinancially autonomous bureau of theTreasury, is charterer and primarysupervisor of national banks (1,705),and primary supervisor of U.S.branches of foreign banks (12).

The Office of Thrift Supervision,established in 1989 as an autonomousbureau of the Treasury, is lead supervi-sor of thrift holding companies (481),charterer and primary supervisor offederal thrifts (837), and joint primarysupervisor of state thrifts (433).

The National Credit Union Administra-tion, set up in 1970, is charteringauthority and supervisor of federalcredit unions (5,189), and insurer of allfederal and most (3,173) state creditunions.

Once again, broadly speaking, there wasa systemic failure in the regulation offinancial markets. Despite the emphasison capital adequacy, capital regulationwas imposed in a way that allowed thebuildup of significant leverage andpromoted procyclicality. In addition, the

fragmentation of regulation, especially inthe United States, as noted above,contributed to regulatory arbitrageencouraging greater institutional risktaking. Moreover, large systemicallyimportant segmentssuch as hedgefunds and the special investment vehiclescreated by bankswere outside thescope of prudential regulation.

The growing consensus on regulatoryweaknesses has led to many reformproposals from different quarters. Acommon theme has been that the balancebetween regulation and laissez-faireneeds to be restored in favor of prudentialregulation that is countercyclical,comprehensive in its coverage of finan-cial institutions, and global in scope andconsistency.

These proposals emphasize, among otherthings, the need for (1) improved incen-tives for prudent risk-taking through suchsteps as reform of compensation andgreater risk sharing on the part of loanand securities originators; (2) muchtighter capital regulation, with stricterlimits on leverage and built-in stabilizersto prevent procyclicality and buildup ofasset bubbles; (3) greater attention toliquidity supervision and funding risks;

(4) better mechanisms for supervisinglarge, complex cross-border financialinstitutions; (5) extending the scope offinancial regulation to ensure that allsystemically important institutions areappropriately regulated; (6) improvedtransparency and reduced systemic risksassociated with derivatives and complexfinancial instruments through greaterreliance on exchange-traded or electronictrading platforms rather than on over-the-counter derivatives transactions; and(7) ensuring that credit rating agenciesmeet the highest standards and avoidconflicts of interest.

Although there may be broad agreementon most of these elements, the devil is inthe details. The views of those whopropose much tighter regulation differfrom those who rely on market disciplineand believe in preserving room for finan-cial innovation.


6/6

Public perceptions and credibility alsomay be a significant issue in that, withmultiple agencies, it may not be clear tothe consumer which agency is respon-sible for a particular issue of regulation orto whom complaints should beaddressed.

There are four prerequisites for goodregulatory governance in regulatory andsupervisory agencies: accountability,independence, integrity, and transpar-ency. Each may be affected by astructural change in the supervisoryprocess. The importance of corporate

governance arrangements arises fromseveral factors:

With regard to the institutional structureof supervisory agencies, this is notsimply an administrative matter; it isimportant to meet the objectives of finan-cial supervision for several reasons. Theobjectives of financial supervision are topromote efficiency and competition, tomaintain market confidence, to protectdepositors or consumers (as appropriate),

and to foster systemic stability. Supervi-sory capacity and the supervisory processitself are the critical elements in attainingthose goals. Above all other consider-ations, institutional structure may havean effect on supervisory capacity and

process and, hence, on the overall effec-tiveness of regulation and supervision,because of the expertise, experience, andculture that develop within particularregulatory agencies and with theapproaches they adopt.

A multiple-agency regime, especially if itallows regulated institutions an elementof choice, creates the potential for regula-tory arbitrage and inconsistent regulationbetween different institutions conductingthe same type of business.

IFM: It is imperative to reformthe structure of regulatorysystem, can you offer concludingremarks and a summery aboutthe importance of orderly func-

tioning regulatory structure forthe countrys financial system?

Mr. Nechemia: I would like to sound anote of caution: We must be careful not tofocus excessively on new regulationsintended to fight the last battle when thenext one could be different. We alreadyhave made a lot of progress in recogniz-ing that supervision should be "risk-based" and that regulation should be"incentive compatible." These principlesshould be kept in mind when we lookahead. The key will be to adapt theseconcepts to the problems of today with

careful thought given to what we expectto happen tomorrow.

they determine the effectiveness andefficiency of the agencies operations;they have a powerful effect on theagencys credibility, authority, andpublic standing; andthey have an important effect on theauthority and credibility of agencysattempt to encourage and to requireeffective corporate governancearrangements within regulated firms.

(a)

(b)

(c)

Given the above, it is clear why the

institutional structure of regulatoryagencies is an issue of both concern (toconsumers, regulators and industryparticipants) and significant. However,the importance should not be exagger-ated. A crucial point is that institutionalstructure does not, in itself, guaranteewhat really matters, namely, the effec-tiveness of regulation in achieving itsobjectives in an efficient andcost-effective manner.


2 0 0 9 J U L Y 39

There must be reforms of the regulatoryand supervisory frameworks. Theevidence suggests that reforms of theregulatory and supervisory frameworksare only part of the answer however.There are a broader set of issues that

includes trade, financial integration, andmacroeconomic policies. Furthermore,policy cooperation at the global levelrequires an adequate institutional frame-work; for this reason, the reform ofinternational financial institutions is onceagain bound to be on the menu of discus-sions.

There exists a great need to focus aboveall things on coherence of responsibilityamong regulatory agencies for particularaspects or objectives of regulation as it isrelated to effectiveness. This coherence,in turn, raises the question of interagencyrivalry and disputes and of the effective-ness of needed information exchange andcoordination.

In the face of current global financialcrisis, I believe, at least more than G 20sshould make coordinated efforts toformulate regulatory system in confor-mity with the global economic integra-tion. We need to consider establishing thenew regulatory system. We cannot putour hopes to save the economy on theremedy of the old system.

regulatory arbitrage: swirling in the eye of the storm (international finance magazine) | ron...

Documents