Barbara Ridpath and Richard Reid review the regulatory landscape in 2009 and predict how it will change in 2010

The last twelve months is probably best seen as the year in which the authorities began to recover their poise in the wake of the events which wracked the financial markets in the course of 2008. While much progress has been made, there are still two major challenges in the year to come. The first appears on the macroeconomic front: how to turn off the tap of extraordinary support measures and contain fiscal deficits without choking off the nascent recovery. The second challenge will be to achieve consensus on some of the thorniest regulatory areas still outstanding, while getting the hard graft of the regulatory details right. This article reviews the regulatory highlights of 2009 and the outlook for financial regulation in 2010.

Regulatory highlights of 2009

At first the policy response in 2009 was concentrated on efforts to stabilise financial markets and prevent an economic meltdown of epic proportions. Hence, policy was often made on-the-hoof, with many decisions being taken at a time when the legal and institutional framework for such decisions were themselves in a state of flux. While some of the economic life-signs were beginning to steady through the end of the first quarter, it would have been a brave policy maker indeed who declared that the worst was over.

For the bulk of the year the focus was on finding a balance between bringing order and calm to the banking system, while simultaneously determining the correct regulatory response. The former was critical to re-establishing the normal process of financial intermediation; the latter was key to ensuring that those parts of the financial sector whose growth had outpaced the supervisors’ ability to monitor them could be brought back into line.

Sometimes the two policy objectives appeared to conflict. Specifically, encouraging the banks to rebuild capital ratios often seemed at odds with the stated desire to support economic activity by increasing available bank credit. Always in the minds of the authorities was the consideration that encouraging lending to certain groups may have contributed to the growth of the credit bubble that preceded the crisis.

As we moved through the end of the first quarter we began to get a more measured regulatory response, which looked in more detail at what the appropriate regulatory architecture should look like after the crisis. In Europe we had the landmark de Larosière Report, in the UK the influential FSA Turner Review, and the US Treasury proposals of the Timothy Geithner. By April, the G20 gave a signal that there was a broad consensus over the need to act decisively and jointly on a number of fronts. However, even as this declaration was being made, it was clear that the coordination of the details was going to be difficult, as differences in approach emerged both within and between countries.

The G20 initiatives provided a clear work plan for the future with emphasis on: strengthening transparency and accountability, enhancing sound regulation, promoting integrity in financial markets, reinforcing international cooperation, and reforming the International Financial Institutions. With immediate effect from April, the G20 created the Financial Stability Board (FSB) from the former Financial Stability Forum, which is now working hard on recommendations ahead of the June 2010 G20 meeting. Membership of both the FSB and the Basel Committee on Banking Supervision was also expanded to include all G20 members, increasing their legitimacy and authority. At about the same time, further national and regional initiatives began to pour forth. As an example, in the UK alone these included: legislation on a new Special Resolution Regime, the Foot Review on offshore financial centres, the Walker Review of corporate governance, and the FSA review of liquidity.

However, while initiative at the international level remained strong, two important components of the debate began to impede progress. First, the existence of philosophical differences among certain nations on the fundamental purpose of financial regulation meant that only issues that could be resolved without confronting this difference were addressed. Second, political haggling at the national and regional levels, and the sad politics of point scoring and scape-goating began to interfere with clear prioritisation of the most pertinent causal issues. The latter risked compounding the complexity of regulation without reducing the likelihood of future financial crises. In some areas there was a concern that the targets for regulatory wrath were populist ones which had little to do with the genesis of the crisis. Tax havens, hedge and private equity funds have been obvious examples here.

This process was also complicated by the growing resistance from some parts of the financial sector to certain aspects of the proposals on the table. Many banks expressed concern over the “unintended consequences” of the combined effect of changes to capital, leverage and liquidity ratios and how international differences could both dampen intermediation and distort competition. However, as the year wore on the public’s distrust of the banking industry grew as the proportions of the bailouts became clearer, access to credit remained restricted and in more recent months, the issue of compensation and bonuses took centre stage.

In the third and fourth quarters of 2009 a number of economies started to stabilise as fiscal and monetary stimulus measures took effect. Much of the emerging world looked increasingly resilient. While economists discussed the alphabetic shape of the recovery: L, W, V, or U (and whether this was a temporary rebound or sustained upturn), policy makers discussed the timing of exit strategies more overtly. Many US and UK financial institutions took advantage of the propitious bond and equity market conditions to raise money to rebuild capital bases and repay government bailouts. Many institutions, having taken full advantage of the steep yield curve which had resulted from quantitative easing, announced record half-year profits less than a year after announcing huge losses.

During this period, European legislators were extremely active with new legislative proposals to reform the regulatory architecture, in particular creating a European Systemic Risk Board (ESRB) with a core role for the European Central Bank, and transforming the three existing regulatory coordination bodies into European regulatory agencies: the European Banking Authority, the European Securities Market Authority and the European Operational Pensions and Insurance Authority. This was groundbreaking in that it gave some authority for these bodies to question decisions at the national level, although significant constraints were added to this before its approval at the most recent European finance ministers meeting.

Less publicly, financial institutions were all the while working hard to address lacunae within their risk management, technology, control and reporting systems and procedures – which were brought to light by the financial crisis – in an effort to have better real time understanding of their exposures and better risk management and stress testing. It is still too early to know whether this is the beginning of a long-term change in culture and behaviour, or an appeasement policy to placate supervisors.

The outlook for 2010

2010 will remain a challenging year as we move from agreement on the broad regulatory response to the ironing out of detailed proposals. The outlook for growth is limited. The tremendous fiscal stimulus, which dampened the effect of the downturn, implies that its withdrawal and subsequent fiscal tightening will necessarily limit growth on the upside. On the regulatory front, the real work now begins: translating good intentions into regulation, but regulation that strikes a balance between improving systemic stability without completely debilitating the financial institutions concerned and stifling competition and innovation. Moreover, some topics, currently stated only as lofty principles, such as cross border crisis resolution and ‘living wills’, must now be translated into harmonisation of crisis procedures and global tools.

Regulatory initiatives fall into three broad categories: efforts to address the early identification of systemic risks, often called macro-prudential regulation, efforts to improve regulation and supervision so that individual institutions are less likely to need public funds in future, and structural reforms of the regulatory architecture. The latter involves both where responsibility for systemic risk monitoring should rest, and whether changes need to be made to unify or separate regulation and supervision of banks, insurers and markets. Legislation on the structure of regulation in the United States should be finalised early next year. Meanwhile, the UK is grappling with the issue of whether the Bank of England or Financial Services Authority should handle regulation. In Europe, as already mentioned, the plans for a new European Systemic Risk Board should take off sometime in 2010. On the ‘nuts and bolts’ of micro supervision, the BCBS is expected to fill in some more detail on its review of the Basel II review before year-end, with the intention of putting proposals up for consultation early next year. They are likely to address: trading book risk, counterparty credit risk, and capital instruments and among others issues.

And many important topics have yet to make it even onto the regulatory agenda. These include two particularly tricky conundrums. The first is the combination of a clear concern over the size, complexity and systemic instability of large, complex financial institutions at the same time that the recent crisis has just reduced the number of institutions in the sector in a wave of consolidation that has left those left standing more important than ever. The second, similar paradox is on the regulatory side. On the one hand we seek regulatory convergence and harmonization so as to prevent regulatory arbitrage, but there is a risk that without diversity, when all supervisors use the same methods and tools, they are all wrong at once. So how do we encourage diversity in bank business models and regulatory models?

Also yet to be tackled is whether the home country should cover the entire cost of bank rescues regardless of the breadth and scope of those operations and assets around the world. Similarly, if the taxpayer is to pay the bail-out, should voters have a say in the scope of activities maintained by a bank under the jurisdiction of its home market?

We may see further attempts by policy makers to address banker’s “behaviour,” the social utility of both finance and financial innovation. It should make for an interesting year ahead.

Barbara Ridpath, is CEO, and Richard Reid is Director of Research at the International Centre for Financial Regulation