Table Of ContentReinventing Financial Regulation P
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A Blueprint for Overcoming Systemic Risk rs
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u
d
Reinventing Financial Regulation offers an analysis of the fundamental flaws that plague
the current system of financial regulation, one built around ideas of “risk-sensitivity”
R
and “capital adequacy.” Author Avinash Persaud argues that while some sensible reforms
have been introduced, a fresh approach—centered on risk capacity—is required. When e
the entire regime is compromised, simply slapping bandages on each new wound will do i
n
nothing to cure the underlying disease.
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Reinventing Financial Regulation goes beyond an urgent call to fix our profoundly
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troubled and damaged financial markets. It is a blueprint for an effective financial
regulation system that could very well save the future of finance. n
t
What would a well-regulated financial system look like? Until now, policymakers,
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financial experts, and leading academics have been content to avoid facing this n
question head–on. We have been offered piecemeal reforms that ultimately leave the
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global financial system exposed to different versions of the same risks that so recently
brought it to its knees. The world economy literally cannot afford to dodge this question
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any longer.
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Persaud’s goal to bring clarity and a powerful simplicity to the financial regulation Reinventing
process results in a systematic and apolitical framework for fixing the world’s fractured a
financial industry and transforming its regulation—not just for today’s financial climate, n
but once and for all.
c
i
This book asks—and answers—the following questions: a
Financial
• W hy is it important to regulate the financial industry over and above the way other l
industries are regulated? R
• W hy do many of the politically appealing ideas like locking up bankers, clawing back
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their bonuses, banning derivatives, regulating international banks internationally, and
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ending tax-payer funded bailouts have less merit than some politically unpopular
Regulation
ideas like capping bankers pay and levying small transaction taxes? u
• W hy are financial regulators most lost when dealing with systemic risk, not consumer l
protection, though it is the latter that holds most political interest? a
• What causes financial crashes? t
• W hy is the current “risk-sensitive, capital adequacy” approach to financial regulation i
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fundamentally flawed and leading to more and bigger financial crashes?
• W hat concrete steps can countries take to construct a new regulatory model based n A Blueprint for Overcoming
around risk capacity that will better protect consumers, countries, and the world
economy from yet another financial boom-bust? Systemic Risk
―
Avinash Persaud
ISBN 978-1-4302-4557-5
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Contents
About the Author ix
Acknowledgments xi
chapter 1: reinventing financial regulation 1
chapter 2: Why Do We regulate finance? 7
chapter 3: What causes financial crashes 25
chapter 4: Why taxpayers need to Be on the Hook 39
chapter 5: How Should We regulate the financial System? 55
chapter 6: putting the new framework to the test 77
chapter 7: protecting consumers 93
chapter 8: How Accounting, credit, and
risk Standards create risk 113
chapter 9: What to Do About complex financial instruments 137
chapter 10: Bankers’ pay 151
chapter 11: Why locking them up Will not Work 163
chapter 12: financial transaction taxes 175
chapter 13: the Shape of financial regulation 201
chapter 14: the locus of international financial regulation 215
Appendix A: Sending the Herd off the cliff edge 235
Appendix B: Banks put themselves at risk at Basel 247
index 251
C h a p t e r
1
Reinventing
Financial
Regulation
Financial regulation has lost its compass and been led astray. The perspective
of this book is neither that of the neoliberal who is instinctively against med-
dling regulators nor that of the unreconstructed Stalinist who is suspicious
of private enterprise. If we are to finance better health and education for
all of our citizens, we need economic growth. Growth requires risk takers.
Too little risktaking starves the economy, feeding economic, social, and politi-
cal malaise. Excessive risktaking allows a few players to flash brightly before
plunging us all into darkness. To achieve a Goldilocks1 amount of risktaking—
not too hot, not too cold, not too large, not too little—requires a fresh take
on financial regulation. This is not to be confused with the decision to have
more or less regulation—the binary choice presented by competing political
ideologies. What we need is a substantial reinvention.
Chapter 2 sets the stage, showing why we regulate the financial sector consider-
ably more than we do other industries. This stems from the singular consumer
protection problems that finance poses as well as the fact that banking is highly
systemic. If a green grocer consistently sells bad apples, you can shop elsewhere
with minor repercussions. By contrast, most people will only buy a few financial
1Goldilocks and the Three Bears by Robert Southey (1837).
2 Chapter 1 | Reinventing Financial Regulation
products in their lifetime—a mortgage, a life insurance policy, a pension, and
perhaps a car loan. Unfortunately they rarely find out if these are bad products
until it is too late to rectify the problem. More importantly, the consequences
of having swallowed the wrong product could be life changing. Perhaps it was
an unlucky decision. But they might also have been persuaded to purchase
something wholly inappropriate by a commission-grabbing salesperson. Much
work is required to protect all consumers from conflicts of interest and the
other causes of the mis-selling of financial products. Further measures are
needed for protecting particularly vulnerable consumers. My thoughts on this
are set out in Chapter 7.
By and large, the problem of consumer protection is understood. Systemic
risk, on the other hand, is much cited but little understood. It is fast becom-
ing a phrase that means so many things that it no longer means anything in
particular. In fairness, while consumer protection and systemic risk are distinct
challenges with separate foundations and remedies, they are not always easy
to differentiate, especially when in the throes of a financial crisis. Taxpayer
bailouts of the financial sector during the highly systemic, Global Financial
Crisis (GFC)2 of 2008–09 caused dramatic increases in public debt for those
countries engulfed by the financial crunch. Amid slumping growth and ris-
ing unemployment, the crisis countries responded with varying degrees of
public-sector belt tightening as well as central-bank largesse. This is not new.
Past financial disasters have been similarly punishing for ordinary members of
the public. The losers can be loosely classified as those most dependent on
public-sector safety nets or with their savings in bank deposits and this time
around the victors have been those with homes and other assets that rose in
value as interest rates sank to zero.
Financial crashes and their responses are as political as they are technical—a
subject I address in Chapter 3. Disgusted by the immorality of the situation,
many justifiably angry people gravitate toward the bad apple theory of finan-
cial crises. They propose cleansing the system by locking up evil bankers and
reclaiming their bonuses. No one doubts there is room to enforce existing
laws more rigorously. But legal solutions offer little redemption. Crashes follow
booms. Blame is widely shared and several of today’s villains were yesterday’s
heroes. Courts are ill-equipped to sort that out in any coherent way.
Dissatisfied in neither seeing a lot of bankers led off in chains nor much change
in bank behavior, voters and populist politicians began chanting “Never again!”
and “Let the banks fail!” When the point is made that letting individual banks
fail can have systemic repercussions, the common response is that bank res-
cues must be self-funded and specifically targeted to ordinary banking and
2Throughout this book the Global Financial Crisis is abbreviated to GFC.
Reinventing Financial Regulation 3
there should be no opportunity for regulatory arbitrage between nations.
Bailouts, it is shouted, must never again be taxpayer funded. Yet it is unclear
that this is possible or desirable and in Chapter 4, I explain that the financial
system is actually incapable of insuring itself against a systemic disaster.
All is not lost. Regulation can be reinvented to be less prone to the extremes
of the boom-bust cycle and the iniquities this pattern brings. However, even
reinvented regulation of the financial sector cannot be done through a single
instrument.
We look at the issues of banning certain financial products in Chapter 9;
restricting bankers’ pay in Chapter 10; the efficacy of pressing criminal law
to change behavior in Chapter 11; using tax policy in Chapter 12; rearranging
regulatory institutions in Chapter 13; and the role of international regulation
in Chapter 14. The greatest inadequacy of financial regulation remains its
inability to deal with systemic risk. That is where this book offers the greatest
reimagination of financial regulation. I build the case in Chapters 3 and 4 and
offer my proposals for dealing with it in Chapters 5 and 6.
The systemic character of banking flows from the nature of the credit econ-
omy. When a house owner borrows money from one bank to pay his builder
for refurbishment, the builder may deposit the cash in another bank. That sec-
ond bank could then use the builder’s deposit to lend to someone else, who in
turn uses that loan to pay another, who makes a cash deposit in a third bank.
One bank’s borrower is thus another’s depositor, and that depositor serves to
fund yet another bank’s borrower, and so on. The failure of one bank, causing
the receiver to pull its loans, will bring down several others. This is the nub of
the systemic risk problem. Connectivity in the banking system runs deep. No
other industry is like this. It is also why regulators should be more wary than
they have been in demanding systemic regulation of other sectors and activi-
ties in finance that are not as fundamentally systemic as deposit-taking lenders.
Shareholders of a bank usually worry only about the loss of their invest-
ment in that particular bank. They do not feel a responsibility to consider
the combined losses of the shareholders, depositors, and borrowers in all the
other banks that would be brought down by the failure of their bank. They
believe that responsibility rests with others, namely the government. From
the perspective of the financial system as a whole, therefore, shareholders
underinvest in the safety of individual banks. One of the guiding lights of finan-
cial regulation—its North Star—is to make all banks take greater precautions
than they would if left to their own devices. These safety measures should rise
where a bank’s size or connectivity increases the probability that its failure will
generate systemic repercussions. Regulation should seek to internalize this social
externality so that bigger, highly connected banks face tougher requirements
than their smaller or less connected competitors.
4 Chapter 1 | Reinventing Financial Regulation
During the two decades or so prior to the GFC, the zeitgeist proclaimed
that markets were the source of much that was right and good in the world.
Governments bore the blame for what was wicked and wrong. Regulators lost
their mojo—their ambition shrunk to encouraging the worst banks to look
like the best. Banking regulation was crafted in the image of what the biggest
banks said they were doing. Worse still, regulators achieved this by effectively
mandating all banks to have the same expensive credit and risk models as the
largest banks. Rather than having the big banks face tougher requirements,
they were handed a competitive advantage. Some of the regulators scurrying
around today wagging their fingers and declaring that no bank is too big to
fail or jail were the very ones who contributed to them bloating in the first
place. Regulators are also guilty of dismissing the concerns of those of us who
argued that the new “risk-sensitive” approach to bank regulation emerging in
the late 1990s would inflame systemic risks.3
Risk sensitivity sounds so correct that many blindly assumed it must be so.
It is utterly wrong. Under the mantra of greater risk sensitivity, prudence,
and transparency, banks were forced to set aside more capital for loans they
thought were risky and less for those they thought were safe. They made
this determination using regulatory-approved common risk models, driven off
publicly available data. However, banks don’t generally get into trouble by issu-
ing loans they already estimate will be risky. Industry practice dictates they put
aside more capital for these risky loans or secure greater collateral—like a
lien on a business owner’s home—and agree on additional covenants. A typi-
cal demand is that the loan is instantly repayable in full unless the borrower
keeps 12 months’ interest on deposit at the bank. Where banks frequently
come undone is by issuing loans to those they believed were safe-but later
became risky. Following the risk-sensitive approach, since the loans were clas-
sified as safe, they set aside the least amount of capital to guard against their
failure. This is why the banks that looked wholly undercapitalized in 2008
were often those that boasted levels of capital substantially above their mini-
mum, risk-sensitive, requirements just 12 to 18 months previously. Its not the
things you know are dangerous that kill you.
Banks were all utilizing similar risk models fed by the same data. Inevitably
their holdings were concentrated in the same assets that the models indicated
provided the optimum mix of return and risk. In Chapter 8, I explain that the
3As the Financial Crisis was emerging, Martin Wolf, Economics Editor at the Financial Times,
speaking at the paper’s Annual Economists’ Dinner in November 2008, in London, said,
“I am not seeking to deny that a few people saw important pieces of the emerging puzzle and
some saw more than a few pieces. In my gallery of heroes is Avinash Persaud, who told us early
and often that the risk-management models on which regulators foolishly relied were absurd
individually and lethal collectively.”
Reinventing Financial Regulation 5
concentrated purchases of these assets, bidding up prices and bidding down
quality, turned these previously safe assets into risky ones. When they turned
sour, the risk models instructed every bank to sell simultaneously. This turned
them from uncorrelated, stable assets into correlated, volatile ones. Bank risk
models were pushed into an apoplexy of selling orders that opened up liquid-
ity black holes in the financial system.4 Signs of this behavior were already
visible during the Asian crisis of 1997–98, the Long-Term Capital Management
debacle in 1998, and the dot-com bust in 1999–2000. Risk-sensitive regulation
added to systemic risk. Regulators sought to make individual banks safe and
ended up making the entire system perilously unsound.5
To work, the risk models required a fictitious view of risk, one in which there
was just one thing called risk that could be dialed up and down. Whenever
regulation failed the regulators would effectively try to dial risk down. Not
only was this shutting the stable door after the horses had bolted but it unin-
tentionally created another risk. Attempts to reduce risk often simply pushes
it elsewhere. When it caused a problem in that new site, regulators there
simply shoved it along someplace else. The systemic implication of this is that
risk kept on being thrust from site to site until it could no longer be seen.
That is a dangerous space for risk to occupy.6
The reinvention of financial regulation must confront the paradox that the
process of anointing something safe actually makes it risky for the reasons I
previously cite.7 Safety is not statistical; it is behavioral. I argue in Chapter 5
that managing risk in the system should not rest on contemporary estimates
of what is safe or risky. Efforts to do so will inevitably fail. Risk sensitivity
should be thrown out of the window. I suggest it is replaced with a new con-
cept of risk capacity. The first half of this book shows how that idea naturally
emerges from a long, hard look at the actual challenges we face rather than
the imaginary dragons we think need slaying.
When an institution has risk capacity it can absorb a risk. Take liquidity risk,
the risk that an asset will fetch a far lower price if one is forced to sell it this
minute rather than sell at a time within the next year or so. In Chapters 5 and 6,
4See Avinash Persaud, ed., Liquidity Black Holes: Understanding, Quantifying and Managing
Financial Risk (London: Risk Books, 2003).
5See Avinash Persaud, “Sending the Herd Off the Cliff Edge: The Dangerous Interaction of
Herding Investors and Market-Sensitive Risk Management Practices” (BIS Papers 2, Basel:
Bank for International Settlements, 2000); reprinted with kind permission at the end of
this book.
6See John Nugee and Avinash Persaud, “Redesigning the Regulation of Pensions and Other
Financial Products,” Oxford Review of Economic Policy 22, no. 1 (2006), pp. 66–77.
7In “Avoiding The Risks Created By Avoiding Risk” (Financial Times, August 27, 2005),
Andrew Hill describes this as the “Persaud paradox”—wherein “the observation of safety
creates risk and the observation of risk creates safety.”
6 Chapter 1 | Reinventing Financial Regulation
I show that a young pension fund that does not need to raise cash to pay out a
pension for five years or more has a capacity for liquidity risk. It can own assets
for an extended time thereby avoiding the worst moments to sell. However,
the same pension fund may have limited capacity to hold concentrated credit
risk. Liquidity risks fall with time, but credit risks rise over time. The probabil-
ity that a credit will blow up in the next hour is much lower and more certain
than the likelihood that it will explode anytime within the next five years.
A bank with a diversified set of borrowers and overnight depositors has the
capability of absorbing credit risks but little capacity to swallow liquidity risks.
The other key tenet of a reinvented financial regulation must acknowledge that
different parts of the financial sector possess varying capacities for absorbing
distinct risks. Moreover, it recognizes that this is a crucial source of systemic
strength. Crude ring fencing of different sectors of the financial system will not
make it safer. All this does is restrict natural fits between risk and risk capac-
ity. Such restrictions increase the system’s vulnerability. We need to promote
an incentive structure that drives risks to the right places. Capital-adequacy
requirements should be based on the mismatch between an institution’s risk
capacity and the risks it is taking across the financial sector. By so doing, we
would incentivize institutions with one type of risk capacity to safely earn the
risk premium from buying assets with that type of risk and to sell other assets
they own to those better suited to holding them. Risks would no longer be
banished from the visible world and left to lurk menacingly in dark corners.
They would instead be drawn to that part of the system where they are best
absorbed. The system would then be safer than its individual parts.
The ideas presented are partly about a fallacy of composition. Trying to make
individual financial firms safe does not necessarily make the financial system
safe. This book is about how you risk manage the financial system from the
start rather than dancing around the individual consequences of not doing so.
After consumer protection, that must be the principal object of regulation
and this book expands on these and related issues. It is a blueprint of how
regulation can be reinvented so that the risktaking necessary for growth and
development is done more safely. Finance is a fascinating subject. All of human
emotions, failings and some virtues can be found there. In addition to argu-
ment, I have shared a number of anecdotes and stories in the hope that you
will enjoy reading this book and will be enticed to join the debate.
C h a p t e r
2
Why Do We
Regulate
Finance?
And Do So Over and Above the Way We
Regulate Other Businesses?
In this chapter, we look at regulation of financial institutions and how it differs
from regulation in other industries.
Introduction: Why Regulate?
The debate surrounding regulation in general, not only of the financial variety,
is polarized. There are those who are so suspicious of private enterprise that
they believe almost everything should be regulated. Others are convinced that
even well-intentioned regulation has such adverse unintended consequences
that bureaucratic red tape should be cut to the barest of threads.
