Will tighter regulations lead to just fatter documents or will they tackle substantive issues?
The strongest push for more comprehensive regulation of financial markets is probably coming from the European Union. In its Summit last month, the EU called for a comprehensive regulatory framework for “all financial markets, products and participants — including hedge funds and other private pools of capital which may pose a systemic risk.” There clearly is a case for stronger regulation of the larger hedge funds: For example, in the United States, while the six largest banks had assets of $6 trillion at the end of 2007, quasi-banks and hedge funds had resources totalling $4 trillion. Given gearing, the exposure to the totality of the financial system would obviously be much larger.
The fact that large hedge funds can create systemic risks was proved more than a decade ago when Long Term Credit Management (LTCM), the hedge fund, collapsed and the US Federal Reserve was forced to initiate a rescue by getting a group of major counterparty banks to invest in it and take control. But, obviously, that was not enough evidence to persuade the US authorities of the need for better oversight of larger hedge funds capable of posing systemic risk. As for private equity, the European Venture Capital Association (EVCA) has accepted the need for tighter supervision.
The European Commission, in pursuance of the call given at the summit meeting, has pledged quick action on the recommendations of a report by Jacques de Larosiere, the former French central banker. These include legislation on standards for hedge funds and private equity, recommendations on remuneration in financial services, and proposals on bank capital for trading activity. The International Monetary Fund (IMF) has also called for reform of the supervisory framework — one of its proposals is for global financial institutions to be supervised by colleges of supervisors from the home country as well as from other countries where the institution has significant presence. The Bank for International Settlements (BIS) has asked banks to be prepared for much higher capital needs. Not to be left behind, the International Organization of Securities Commissions (IOSCO) has also proposed closer supervision of both the cash and derivatives markets in commodities: It may be recalled that the Organization of the Petroleum Exporting Countries (Opec), had alleged last year that the steep rise in the price of oil was driven far more by speculation than by a gap in demand and supply.
Critics of tighter regulation and controls on remuneration argue that this may stifle innovation. It’s important, however, to keep in mind that all the major, genuine innovations in finance over the last 60 years have come from places other than the commercial/investment banks:
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In fact, too many “innovations” that have been fathered by commercial and investment banks are aimed at getting around regulatory restrictions, avoiding taxes, creating complex instruments which help to hide the pricing and risk, and rarely serve any useful economic purpose — other than for the structures themselves! As James Tobin, the Nobel Laureate, said back in 1984: “I confess to an uneasy...suspicion, perhaps unbecoming in an academic, that we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services.....I suspect that the immense power of the computer is being harnessed to this ‘paper economy’, not to do the same transactions more economically but to balloon the quantity and variety of financial exchanges”. Perhaps he was too polite to add: “For the benefit of the structurers”! Over the last 25 years, of course, this ballooning of financial transactions has grown exponentially!
Overall, tighter regulation does seem to be on the cards. The question, of course, remains what form it will take. Will it, for example, merely lead to extremely fat documents which nobody really reads, which, like the bikini, bare the peripherals and hide the essentials? The offer documents in relation to CDOs, which are at the heart of the huge losses currently being recorded by the banking system, often ran to 500-600 pages, but obviously were ignored by the investors. Or would it tackle substantive issues like the type of assets to be considered for calculating Tier I capital — deferred tax assets for example? Would it disallow commercial banks from engaging in proprietary trading, managing hedge funds and private equity? Or perhaps specify maximum gearing? While conforming to the capital ratio of 8 per cent, some banks had gearing of 30/40 (in the case of one investment bank before the crisis, even 50!).