Intended, unintended and unexpected consequences of regulation

There are two ways of reading these lines from the new Bank for International Settlements (BIS) annual report: “Despite substantial efforts to strengthen their capital and liquidity positions, advanced economy banks still face market scepticism. As a result, they have lost some of their traditional funding advantage relative to potential customers.”

One reading of course is the market believes banks need to do even more to bolster the perception of security. After all, the Miller-Modigliani theorem often cited by regulators boils down to the safer the institution, the lower the cost of its funding. Hence more equity, rather than weighing on returns, is offset by cheaper debt and equity due to lower risk premia.

"To ignore the role regulatory imposts and ongoing uncertainty around future regulation are playing is to ignore the real world."
Andrew Cornell, Managing Editor

But the other reading is one many market participants – including ANZ’s chief executive Mike Smith – have noted: the market is simply not rewarding marginal increases in theoretical stability, particularly extra capital.

In that reading, the market scepticism resulting in lower book values is not so much security concerns but a rational discounting of bank stocks due to higher capital costs and the ongoing uncertainty around new regulatory measures.

(And, in the northern hemisphere, the massive operational risk costs of rogue trading, market rigging, collusion and a raft of other cultural defects.)

BIS general manager Jaime Caruana noted “the less good news is that banks have yet to regain full market confidence. The price-to-book ratios of large banks from advanced economies are still hovering around 1, which is about half the ratio for non-financial firms, if not lower”.

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“These low valuations may reflect uncertainties about their business models, including doubts about the consequences of having to live with very low and flattened yield curves for a long time. Moreover, banks’ exposures to interest rate risk and also credit risk have increased.”

 The BIS is right to emphasise maintaining risk sensitivity is a priority and regulators and supervisors do need to be alert about interest rate risk but to ignore the role regulatory imposts and ongoing uncertainty around future regulation are playing is to ignore the real world.

Caruana spoke of “blind spots” in the international monetary and financial systems about the longer term effect of policies but the BIS has its own blind spot around self-assessment – something which has even been raised by G20 members.

This is not to say regulatory regimes, capital imposts and other measures don’t need to be tougher but surely some analysis of the role, cost and impact of measures to date should be expected?

The annual BIS annual report is of course an extremely thorough and methodically argued and supported document but – as has been the case too regularly in the past – it needs a mirror.

The regulatory wave since the crisis has been so large and so complex it has had intended, unintended and unexpected consequences.

That’s why many in the financial services industry and indeed an increasing number of regulators have argued it is time for a stock take – not just of the impact of individual measures but how these measures have acted in concert.

What is needed, in effect, is the same kind of analysis the BIS has applied to its consideration of monetary policy.

In his remarks prior to the release of the annual report, BIS Monetary and Economic Department head Claudio Borio noted “rather than promoting sustainable and balanced global growth, the system (of unprecedented low interest rates and excess liquidity) risks undermining it. It has spread exceptionally easy monetary and financial conditions to countries that did not need them, exacerbating vulnerabilities there”.

“Paradoxically, an easing bias in the short term may end up being contractionary longer-term, as financial imbalances unwind.”

This is not literally analogous to the situation with regulation but it is exactly the kind of impact analysis that’s needed.

The BIS does indeed highlight some issues where post-crisis regulation has reshaped markets but there is a curious reticence in taking credit for the changes.

For example, in his press conference Borio noted “as banks have retrenched post-crisis, risks have been migrating to other parts of the financial system. Persistent exceptionally low interest rates have exacerbated this, by weakening the financial strength of insurance companies and pension funds and by encouraging an aggressive search for yield, partly channelled through a burgeoning asset management industry. These risks should be monitored and managed closely.”

But part of the reason banks have “retrenched”, particularly from more capital intensive or higher risk-weighted activities, is a direct consequence of regulation.

Now this is not necessarily a bad thing, a profound force in the crisis was an under-pricing of risk by financial institutions, exacerbated by a system which ultimately allowed profits to be privatised while the crisis was socialised.

The BIS annual report devotes attention to one of these unexpected if not unintended consequences of the regulation, a decline in so-called market making activities by global banks.

“Recent indications of reduced market liquidity have drawn policymakers' and analysts' attention to important providers of such liquidity: specialised dealers, also known as market-makers,” the report says.

“There are various drivers of market-makers' perceived retrenchment. Some relate to dealers reassessing their own risk-taking behaviour and the viability of their business models post-crisis. Others have to do with new regulations, which aim to bring the costs of market-making and other trading-related activities more closely in line with the underlying risks and with the risks that these activities generate for the financial system.”

As the BIS says “attaining this policy goal would ensure a transition to an environment with possibly lower, but more robust, market liquidity”. Which is good in theory, much more problematic in the real world.

The bank doesn’t analyse this development completely. It notes market-makers are important providers of liquidity services and by committing their own balance sheets, they stand ready to act as intermediaries during “transitory supply-demand imbalances” in markets.

“It is generally acknowledged that underpriced market-making activities contributed pre-crisis to ‘liquidity illusion’, ie the misleading impression that liquidity would always be abundantly available,” the BIS says.

“After the subsequent bust, market liquidity was eroded by the decline in banks' inventories of corporate bonds and other trading securities. Understanding the drivers of this recent development is necessary for assessing the robustness of market liquidity going forward.”

Quite – but a key part of understanding the situation is a proper assessment of the role of regulation.

At a broader level, financial risk is migrating away from traditional holders such as banks towards the “shadow” banking system or, perhaps less pejoratively, the market-based funding sector.

Again, this may well be desirable but it seems to have taken the BIS by surprise – or at least they don’t well analyse the role of new regulation.

“As these investors (insurance companies and pension funds) offload risks onto their customers and banks retreat from traditional intermediation, asset managers are taking on an increasingly important role,” the BIS says. “Regulatory authorities are carefully monitoring the financial stability implications of the growing asset management sector.”

As the BIS acknowledges and indeed thoroughly analyses, emergency responses to financial crises have consequences, not all expected. Indeed, acute treatment can ultimately lead to chronic dysfunction. The same analysis should be applied to regulatory change.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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