COMMENTARY

Summer 2010

by Susan Phillips

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The differences in approach to bank regulation identified by Avinash Persaud, which appear to be emerging between the U.S. and Europe, may be less attributable to culture or politics than they are to differences in the legal and market environments in the two regions. But even those differences are trumped by the fact that banking and financial markets are so globalised that regulators and legislators must take into account not just initiatives across the pond, but around the world. Many banks operate globally and can locate anywhere to avoid unduly restrictive regulation and even domestic banks must compete with global institutions. So legislators and regulators are painfully aware that they have to pay attention to regulatory initiatives elsewhere.

The challenge for all these policymakers is to develop regulatory solutions that actually address the real problems, taking into account their own domestic financial, institutional and market environments, while at the same time not unfairly disadvantaging domestic institutions vulnerable to global competition. In the seemingly slow-moving financial reform process, some common themes are emerging in the regulatory fixes being proposed across regulatory zones. For example, most agree that adequate capital is key and that it must be appropriately risk adjusted for the business cycle and market conditions.

Persaud underestimates “however” the U.S. emphasis on capital, perhaps because it is less controversial and thus gets less attention. Capital adequacy is difficult to legislate because there are so many variables, and is thus best delegated to the regulators. In fact, the extensive Supervisory Capital Assessment Program (SCAP) undertaken by U.S. bank regulators last year, and the subsequent increased capital requirements, demonstrate the American belief that adequate capital is necessary.

Another point of intersection in the regional financial reform proposals identified by Avinash Persaud is the “too big to fail” issue. Looking at a potential failure and fearing systemic fall-out, regulators have historically interceded, perhaps to avoid failures on their own watch. Retrospective reviews of these incidents often suggest that letting the entity fail would not have caused major ripple effects, and that the cost to the system of increased moral hazard is far worse. Persaud observes that “concentrat[ing] our efforts on making sure banks are not ‘too big to fail’ is partly based on illusion,” but I suspect that the reason for so much attention to this issue is that the longer the issue is examined, the more elusive solutions seem.

I am not as sceptical as Persaud about the risk sensitive approach to regulation, but, definitely think it needs adjustment. The two adjustments he suggests, including business cycle recognition and asset/liability maturity matching, could also be augmented by taking into account market conditions and implementing some institutional reforms. The latter two risk assessment adjustments may be U.S.-centric issues because of greater American reliance on liquid markets for capital formation and mortgage financing than in Europe. Fragile market conditions and the health of the securitisation market and its institutions should be factors in credit risk assessment by U.S. banks. The marketing of mortgage financing in the U.S. also has required regulatory attention.

So while some common themes are clearly emerging in the regulatory proposals being formulated in both the U.S. and Europe, there are differences in their market and institutional situations that will produce some differences in regulatory regimes. The challenge for legislators and regulators is to fashion solutions to address the real problems while not unfairly disadvantaging domestic banks that are now competing globally.