EACT/Raeburn: Financial regulation - Winning the battle and the war; but what about the future?
16 July 2012
As we look beyond the crisis – and the resultant huge strain that we currently observe on both the financial system and its regulators – what type of financial system is in the interests of the real economy? asks Raeburn. And will the banking system deliver what the real economy needs?
The campaign to protect the real economy users of derivatives from the ill-considered G20 regulatory instruction to policymakers was right and necessary. It is therefore logical that we should continue to push for the modification to Basel III that will preserve the value of the EMIR and Dodd-Frank exemptions.
But as we look beyond the crisis – and the resultant huge strain that we currently observe on both the financial system and its regulators – what type of financial system is in the interests of the real economy? The structure and the values needed are fairly obvious:
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market risk and return transparency in all financial instruments;
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credit risk transparency for all derivatives’ counterparties;
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stability and effectiveness in regulatory oversight;
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credible market and credit controls within banks (no surprises….); and
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honesty and trust in the marketing of financial instruments (no bundling…).
Will the banking system deliver what the real economy needs? That brings me back to the question I posed above [see link to full article below]: the battle and the war may be in our pockets but what about the future?
I see a world in which banks will be forced (rightly) to go through major change by splitting out activities that cannot be combined within one overall entity and splitting the marketing of financial products, so that each product is bought by end users based on its merits. So farewell to the proprietary trading that must be underwritten by a combination of traditional retail and commercial banking or the taxpayer or the shareholders (assume any combination of that you consider realistic) and farewell to bundling designed to obfuscate financial transaction costs.
I also see great risk in even getting the banks to the position where they can implement the changes that politicians, regulators and society will demand. Some banks will buckle under the combination of capital requirements and eurozone change.
And I of course see profound ‘forced’ deleveraging of bank balance sheets notwithstanding all the underlying arguments for economic stimulus that will also be seen as pressing.
Corporates will want to look beyond the traditional financial system for their counterparties – these do not necessarily need to be restricted to financial institutions. Just as individuals and very small businesses have already responded to the opportunity to engage peer-to-peer, corporates and pension funds should engage more directly with each other for both funding and hedging.
The battle over derivatives will therefore be increasingly irrelevant in the longer term. The global financial supervisors will undoubtedly try to erode the exemptions, as these do not ‘fit’ with their view of the world (regulatory capture?). End users in the real economy need to think ahead to the continuation of a flawed and fragile financial system and consider how they can reduce their dependence on it. We need a financial system less dependent on the financial institutions. Such a system would probably be less liquid (so it may not be possible to implement a hedging strategy in seconds) but it would certainly have lower systemic risk: the failure of a counterparty would only affect the other counterparty rather than the financial institutions.
© EACT
