A practical approach to regulation of financial risk
According to experts, financial regulation today suffers due to the divergence of theory and practice.
In theory, it is generally accepted that the core purpose of financial regulation is to mitigate systemic risks but, in practice, the regulatory rules are focused entirely on risk-taking by individual firms.
In a recent article, John Eatwell and Avinash Persaud have suggested following three new proposals which can form a better approach to regulation.
First, the regulator should conduct system-wide stress tests of those scenarios most likely to produce systemic stress – such as a 40 per cent drop in house prices. Fears of a meltdown in global house prices were not rare before the crisis. These tests will probably underestimate spillover effects, but the information gleaned from them could help regulators estimate these effects and consider mitigating action.
Second, the regulations should be targeted at highly leveraged institutions, whatever their legal status. Today, leverage is a characteristic of companies throughout the financial system. It is this leverage – when coupled with short-term funding liquidity – that threatens market gridlock in a disintermediated financial system. We need to switch the attention of the central bank and the regulators from an institutionally defined approach to a functionally defined approach.
Institutions are not born with original sin or original virtue; it is their behaviour that can have potentially damaging systemic implications.
Third, a clear distinction must be made between a capital charge and provisioning that is available to cover losses in a downturn. One of the main problems is that a minimum capital requirement is a charge, not a buffer. If resources are to be available in the downturn, then they must be freely released as necessarily as they have been compulsorily accumulated. Because the economic cycle is the big source of systemic risks, experts have suggested that capital charges should be raised in a boom and relaxed in a slump. The point is that counter-cyclical charges should be based as much as possible on systemic phenomena and less on the characteristics of the individual firm.
According to them, the above measures do not take care of the cross-border problem which could completely upset the calculations but, if widespread improvement is to be achieved, the Basel committees and the Financial Stability Forum must shift away from sole reliance on the new Basel consensus of regulation – greater transparency, more disclosure and more market-sensitive risk management at the company level – and instead develop practical systemic proposals.
Contributed by:
Prof Bikramjit Sen
(Globsyn Business School)
Source: http://www.ft.com/cms/s/0/4ae56ca0-72a8-11dd-983b-0000779fd18c.html
According to experts, financial regulation today suffers due to the divergence of theory and practice.
In theory, it is generally accepted that the core purpose of financial regulation is to mitigate systemic risks but, in practice, the regulatory rules are focused entirely on risk-taking by individual firms.
In a recent article, John Eatwell and Avinash Persaud have suggested following three new proposals which can form a better approach to regulation.
First, the regulator should conduct system-wide stress tests of those scenarios most likely to produce systemic stress – such as a 40 per cent drop in house prices. Fears of a meltdown in global house prices were not rare before the crisis. These tests will probably underestimate spillover effects, but the information gleaned from them could help regulators estimate these effects and consider mitigating action.
Second, the regulations should be targeted at highly leveraged institutions, whatever their legal status. Today, leverage is a characteristic of companies throughout the financial system. It is this leverage – when coupled with short-term funding liquidity – that threatens market gridlock in a disintermediated financial system. We need to switch the attention of the central bank and the regulators from an institutionally defined approach to a functionally defined approach.
Institutions are not born with original sin or original virtue; it is their behaviour that can have potentially damaging systemic implications.
Third, a clear distinction must be made between a capital charge and provisioning that is available to cover losses in a downturn. One of the main problems is that a minimum capital requirement is a charge, not a buffer. If resources are to be available in the downturn, then they must be freely released as necessarily as they have been compulsorily accumulated. Because the economic cycle is the big source of systemic risks, experts have suggested that capital charges should be raised in a boom and relaxed in a slump. The point is that counter-cyclical charges should be based as much as possible on systemic phenomena and less on the characteristics of the individual firm.
According to them, the above measures do not take care of the cross-border problem which could completely upset the calculations but, if widespread improvement is to be achieved, the Basel committees and the Financial Stability Forum must shift away from sole reliance on the new Basel consensus of regulation – greater transparency, more disclosure and more market-sensitive risk management at the company level – and instead develop practical systemic proposals.
Contributed by:
Prof Bikramjit Sen
(Globsyn Business School)
Source: http://www.ft.com/cms/s/0/4ae56ca0-72a8-11dd-983b-0000779fd18c.html
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