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Home > Regulation Viewpoints > Regulation after the Crash

Regulation Viewpoints

Regulation after the Crash

by Viral Acharya and Julian Franks

Current Regulatory Problems

Many of the issues facing us as we work through the full impact of the credit crunch and the ensuing meltdown in the financial sector are quintessentially empirical issues. They include the extent to which opaque off-balance-sheet activities and mark-to-market accounting exacerbated the banks’ problems. These issues will require a little time to study fully.

There is, therefore, a real danger that the many temporary measures we see being taken by governments around the world will be set in concrete before the issues involved have been fully digested and their implications and lessons understood. One has to hope that wisdom will prevail and that temporary solutions will remain temporary until we are all a great deal clearer as to what has happened and how we can fix it.

Here we raise a number of points that we believe are worth considering. For example, one thing that is emerging from the current downturn is that this recession is really going to test insolvency procedures, both in the United Kingdom and across Europe. There are two elements to this, namely insolvencies for traditional companies and insolvency procedures for banks and financial institutions. We shall confine our comments to the latter.

Our view is that we could benefit greatly by extending the insolvency provisions that apply to utilities to the financial services sector. In the event of a utility company failing, a special administrator regime can be applied, taking control of the company and reorganizing it in a way that takes account of stakeholders other than creditors and shareholders. At present, our insolvency laws require administrators to focus only on the needs of these two groups. However, in the special utility regime, customers come first and the regulator has the freedom to arrange matters to prioritize continued service to customers.

We are seeing a de facto move in this direction with the nationalization of the banks. However, this is not quite the same as the “ring fencing” of the utility assets. When Enron imploded, because of the special utilities regime, the assets of Wessex Water, which was wholly owned by Enron, were ring-fenced from the company’s nonregulated assets. The special administrator was able to take control of those assets and run them not just for the shareholders and creditors, but also to the benefit of water consumers. This created a significantly different set of circumstances to those with which a traditional insolvency practitioner deals.

This kind of regime dates back to the 19th century, where the United Kingdom passed special administration rules for railways that prevented creditors from tearing up the railway lines to recoup their losses from railways that had gone bust.

The United States did not follow suit and in the end the US government had to step in and break contracts to stop creditors from ripping up the tracks. Similarly, today, with busted utility companies, creditors are unable to recoup their losses by digging up the pipes for scrap.

Policymakers should give some thought to these special insolvency regimes when contemplating the future of the banking sector. The question is: what kind of bankruptcy regime do we need, going forward, for financial services companies, and to which organizations should such a regime apply? Banks? Insurance companies? Investment Banks? All of them or just a select few?

Another aspect of regulation that will have to be thought about very carefully is regulatory arbitrage. Because deposit insurance makes the cost of deposits for banks lower, what you really want to prevent, in these circumstances, is banks using the finance raised within the regulatory regime to subsidize the purchase of assets somehow that are (or, at least should be) outside the regime.

So, how do we prevent banks from using assets which are partially or fully guaranteed and which therefore have a relatively low cost of capital, from competing unfairly in other markets? How can a regulatory regime ensure that, in the event of subsidized funds being used outside the ring fence that the conventional—i.e., the unguaranteed—cost of capital is fully recognized?

One way of solving the problem would be for central banks to charge banks a risk-based, “marked-to-market” fee for their government guarantees. It would ensure that banks would face the full cost of capital once they moved outside the ring fence of protected assets. If the central bank does not charge a fee, or charges too low a fee, then the regulator (and ultimately government) has to ask itself how it is preventing regulatory arbitrage.

Another crucial point, of course, concerns off-balance-sheet assets. There is no question but that off-balance-sheet assets such as Credit Default Swaps (CDSs) and Collateral Loan Obligations (CDOs) have been very serious causal contributors to the present crisis. Regulators, for reasons we and many others do not fully understand, have allowed this to happen in an uncontrolled way, and that game is now over. Already we are seeing the implementation of central clearing houses for CDSs.

The more subtle point is that banks were able to keep certain types of assets off their balance sheets because these assets were deemed to be “nonrecourse” assets by regulators. However, in most of the asset-backed commercial paper conduits there was, in fact, explicit recourse in the form of close to 100% liquidity and credit enhancement by sponsoring banks.

Even in the case of SIVs, where such enhancement was not complete, it is clear that the sponsoring bank stood behind those assets as far as its reputation was concerned. This is why so many of the SIVs whose assets lost liquidity during the sub-prime crisis were taken back by banks onto their balance sheets.

Thus, the so-called “credit risk transfer” innovations employed during 2003 to the second quarter of 2007 were aimed at gaming regulation and taking on excessive leverage and risk, rather than generating economic efficiency. This is a very important point for regulatory authorities to get to grips with and we suspect that, when they do, it will lead to a much tighter definition of what banks can and cannot do. Once this happens, or even looks as if it is on the cards, you will get a predictable hue and cry about “the dead hand of regulation stifling innovation in the financial sector.”

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Further reading

Books:

  • Acharya, Viral and Matthew Richardson. Restoring Financial Stability: How to Repair a Failed System. Hoboken, NJ: Wiley, 2009.
  • Bagehot, Walter. Lombard Street: A Description of the Money Market. Chichester, UK: Wiley, 1999.
  • Bebchuk, Lucian, and Jesse Fried. Pay without Performance: The Unfulfilled Promise of Executive Compensation. Cambridge, MA: Harvard University Press, 2004.
  • Dewatripont, Mathias, and Jean Tirole. The Prudential Regulation of Banks. Cambridge, MA: MIT Press, 1994.
  • Kindleberger, Charles P., and Robert Z. Aliber. Manias, Panics, and Crashes: A History of Financial Crises. 6th ed. Basingstoke, UK: Palgrave Macmillan, 2011.
  • Rochet, Jean-Charles. Why Are There So Many Banking Crises. Princeton, NJ: Princeton University Press, 2008.

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