OMFIF: Hazards of relaxing financial reform

06 March 2017

At a sensitive time for the world economy, there are calls in the US and Europe to undo parts of the reform programme. But legislators and regulators should beware of the hazards of relaxing, suspending or back-tracking on past advances.

[...] The Systemic Risk Council has been tracking the debates about the Dodd Frank regulatory reforms in the US. We are concerned by reports that the Basel Committee on Banking Supervision, and even central bank governors and heads of supervision who oversee the prudential standard-setters, have been debating softening their plans for capital standards in the face of intense industry pressure.

That would be a perilous course. When bad times come, as sooner or later they will again, strong banks lend, weak banks do not. The jurisdictions that took the earliest, most determined actions to build financial system resilience have benefited from more solid macroeconomic recovery than those of their peers adopting a more gradual or less committed reform strategy.

Under what the SRC calls the ‘five pillars’ of the shared reform programme, the G20 has required a more resilient financial system, so as to reduce the probability of failure and to avoid fiscal bailouts when intermediaries do fail. These five pillars remain as vital as ever.

Individual firms are required to carry more equity capital, in proportion to the social and economic consequences of their failing. Banking-type intermediaries have been required to reduce materially their exposure to liquidity risks. Regulators have been empowered to adopt a system-wide view to ensure the resilience of all intermediaries and market activities materially relevant to the resilience of the system. The G20 has simplified the network of exposures among intermediaries by mandating that, wherever possible, derivatives transactions be centrally cleared by resilient central counterparties.

Crucially, enhanced regimes have been established for resolving financial intermediaries of any kind, size, or nationality so that, even in a crisis, essential services can be maintained to households and businesses without taxpayer solvency support.

These five elements of regulatory reform have been accompanied by some major developments in prudential supervision, notably regular stress testing of key intermediaries and service-providers.

These advances are put at risk by voices calling for dilution at a time when world debt has continued to increase. Far from being a moment to relax any of the five pillars of reform, it may be prudent to adopt tougher policies while leading countries replenish their macroeconomic arsenal and try to lower debt levels.

The reform programme was not calibrated for a world where productivity growth has proven elusive, the debt overhang has increased, and macroeconomic stimulus capacity is stretched. In these circumstances, regulatory policy-makers should consider whether to require banks (and possibly some others) to carry more equity than prescribed for the ‘steady state’ in the years immediately following 2008-09.

When the next recession comes, central banks and fiscal authorities will not have nearly as much firepower as they could deploy in 2009 and maintain until now. Governments and legislators should not impede further efforts to build a resilient financial system that can serve households and businesses through thick and thin – a precondition for sustaining dynamism and prosperity.

The authorities should resist siren voices urging lower equity standards for big and complex firms, slacker liquidity requirements, retreat on central counterparties, or dismantling of the new resolution regimes.

Such action would endanger the welfare of citizens and lead to additional, uniformly unpopular, taxpayer-funded bailouts. It would expose economically marginalised industries and regions to even greater risks than those caused by changes in the real economy.

Almost a decade after the start of the crisis, now is not the time to bow to financial industry lobbyists or to short-term temptations. Policy-makers must be discriminating as they review the work of the past decade – leaving stability as a priority.

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