14 January 2013

Acharya/Öncü: A better way to design global financial regulation

This columns argues that at a time of crisis, financial regulators were forced to act on systemically important assets and liabilities, rather than just on the individual financial institutions holding them.

Even ignoring the issue of regulatory arbitrage and shadow banking, the progress on the global implementation of new financial regulations has been slow. The main reason behind this is that many systemically important financial institutions operate across borders, but there are different styles and interests of regulators in different countries.

There is, however, an alternative and better design for global financial regulation: one that is likely to harmonise existing regulations and is reasonably immune to the risks posed by shadow banking evolution.

As the authors argued at the Federal Reserve conference in Washington in March 2012, regulators such as the Financial Stability Board should design the architecture of global finance around the safety and soundness of systemically important financial instruments (view article).

Examples of systemically important financial instruments include demand deposits, repos and over-the-counter derivatives on the liabilities side. Such liabilities, when faced with losses in case of counterparty’s default, would trigger runs on other entities. On the assets side, they are potentially illiquid, high risk assets financed through systemically important liabilities. Fire sales of such assets lead to a collapse in their value inflicting collateral damage on other holders of such assets. Examples include exposures to asset-backed securities backing asset-backed commercial paper and mortgage-backed securities backing repurchase agreements (‘repos’).

Why design regulation at the level of these assets and liabilities? The point is to regulate all institutions holding such assets, regardless of their home country or whether they are deemed systemically important by a regulator in another part of the world.

What would the regulation of such assets and liabilities entail?

It would require dedicated utilities, such as ‘clearinghouses’ for derivatives. These utilities, operating at the level of individual assets and liabilities (for example, a ‘repo’ clearinghouse), would deal with defaults by ensuring orderly liquidation of positions. And, recognising that such liquidation poses significant risks, there would be limits imposed on the risk of positions in the first place. This could be achieved through upfront margins, variation margins based on changes in market values, position limits, and in extreme cases, imposing circuit-breakers.

The Financial Stability Board can coordinate at the global level the setting up of such utilities and can harmonise and enforce their risk management standards. This would be far easier than designing regulations that operate at the level of individual institutional forms. If shadow banking develops newer assets and liabilities, then, as and when they mature (e.g. when the become commoditised or standardised), newer utilities would be introduced in the financial sector.

The Federal Reserve, the Bank of England and the ECB set up several facilities to halt a total financial collapse during the heydays of the ongoing global financial crisis. These have invariably been facilities set up for systemically-important financial instruments.

For instance, the Fed introduced the Term Auction Facility, which auctioned term loans to depository institutions, and the Primary Dealer Credit Facility, which provided overnight loans to primary dealers, to effectively lengthen the maturity of their systemically important liabilities. The Fed’s Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility and Term Asset-Backed Securities Loan Facility, which provided liquidity directly to borrowers holding systemically important assets.

Stated differently, financial regulators around the globe were forced in the midst of a crisis to act on systemically important assets and liabilities, rather than just on individual financial institutions holding them. The key is to recognise the need for such action ahead of time and build the essential infrastructure to ensure that excessive risk-taking is discouraged and markets know that regulators have an orderly resolution plan.

Full article

© VoxEU.org