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Regulation: not enough lifeboats. Or too many?

Following the Titanic disaster – the shipwreck not the movie – the global shipping industry and governments vowed to make sea travel safer.

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The Titanic, infamously, lacked sufficient lifeboats so new laws were brought in requiring many vessels to be retrofitted with more boats.

" We cannot chop the wings with which banking can fly but we need to clip its speed so that it does not crash and hurt itself."
SS Mundra, Deputy governor of the Reserve Bank of India

The SS Eastland was one of those. But its class of ship already had a record of instability and in 1915, while moored in Chicago waiting to ferry revellers to a festival, it tipped over. Thousands drowned. The subsequent inquiry found the addition of new lifeboats had made an already top heavy ship a disaster waiting to happen.

Randall Kroszner of the University of Chicago, Booth School of Business and NBER, uses this example in his paper “Unintended Consequences of Financial Innovation and Regulation".

In developed markets, including Australia and New Zealand, the post-financial crisis regulatory agenda is playing out at the margins of the financial system, despite the noise.

Whether capital levels for banks or liquidity requirements across the sector, the ambitions of the regulators are achievable, the spirit of their actions - if not the letter - broadly accepted and the costs will be borne by customers and shareholders.

Some services will become more expensive, returns to shareholders reduced. But there is little evidence to show profound impacts on economic growth in advanced markets – indeed the greatest challenge is one of coordinating and implementing new regulation to avoid conflicting or self-defeating outcomes.

It's hardly loading lifeboats on a top heavy and listing ship.

But in emerging and developing economies the impact of the response to what was a developed market crisis is far more significant.

Seemingly obvious anti-money laundering regulation, designed to cauterise illegal money flows to terrorism and organised crime, risks cutting off crucial flows of cross-border remittances to families and small businesses. Correspondent banking arrangements which allow business to be linked by their home country bank to a trusted peer in an export market may be severely constrained.

And new capital requirements, intended to make the global financial system safer, may have the unintended consequence of impeding financing of critical infrastructure in the emerging world.

These are themes the B20, a global business lobby, has highlighted to the G20 group of finance ministers. As the B20 said in its Financing Growth policy summary “many emerging markets are coping with the prospect of both seeking to develop their markets whilst at the same time changing some of the fundamentals to accommodate global regulatory changes".

The Basel-based Financial Stability Board, set up by the G20 to coordinate the response, is certainly not blind to this challenge and has built into its mandate the requirement to monitor any unintended consequences of regulation.

But as the deputy governor of the Reserve Bank of India, S S Mundra, noted in a recent address, “even as the standard setting bodies (SSBs) have embarked upon various regulatory reforms to nurture the financial system out of the quagmire it had gone into before the outbreak of the crisis, we feel it is worthwhile to deliberate upon the unintended consequences of the new international regulatory/supervisory measures and chart out ways to counter the potential adverse fallouts".

Clearly, crises like 2008 have long term, horrific costs across societies. But as Mundra says “an underlying tension around the trade-off between financial stability and economic growth persists despite impact assessment studies showing results to the contrary".

His view, expressed memorably, is “we cannot chop the wings with which banking can fly but we need to clip its speed so that it does not crash and hurt itself".

With a focus on India, one of the largest EMDEs, Mundra identified five key unintended consequences, starting with the impact on GDP.

“Economies need to brace up to the fact that the new regulations would have an adverse impact on their economic growth," he said, as well as the impact on infrastructure financing; the impact on finance for micro, small and medium-sized enterprises; the impact of liquidity prescriptions; and the impact of total loss absorbing capital requirements (TLAC).

Again Mundra is not arguing against the new regulatory regime, rather as a central banker he is making a critical argument around calibration, coordination and the recognition of the cost of requirements. There can be second order impacts.

For example, he notes the greater need for bank mediated finance in EMDEs, finance typically supplied at the top end by more international banks and at the smaller end by less sophisticated domestic banks.

“These economies play host to several G-SIBs (globally systemically important banks) and hence they compete with non-G-SIBs in the same market," he noted. “There is potential for spill-over impacts and non-G-SIBs could be forced by the market to hold higher levels of capital on similar levels as the G-SIBs.

“There is also a likelihood of the G-SIBs present in the EMDEs curtailing their operations. Either of these developments would impact the supply of credit and would be negative for the growth prospects in these economies."

Infrastructure financing is another potential issue, despite the development of new institutions like the China-sponsored Asian Infrastructure Investment Bank, given the enormous need for projects.

As Mundra says “India has a growing population and has just crossed the tipping point when it can sustain a high growth rate in the global economy, serving as one of the engines for world growth".

“However, to facilitate this it needs to make massive infrastructure investments. To achieve average growth of 7 per cent per annum during the next five years, the investment requirements have been estimated at Rs.280 trillion (US$ 4667 billion) at current market prices. These are colossal numbers that cannot be realised if bank financing gets restricted in the quest for reinforcing buffers for the banks. So clearly there are limits to regulatory stringency, especially as emerging markets strive towards convergence in per capita incomes."

In Kroszner's paper he posits another unintended consequence. He looks at the demand for “safe" collateral such as US treasury bonds and whether the creation of an artificial scarcity of these instruments might actually offset the benefits of banks holding more of them.

The answers are not easy. Kroszner also notes the development of mortgage securitisation markets which created a pooled national market for mortgages out of what was a collection of local ones. But it was this market that fuelled the crisis.

He notes some crucial policy implications: It is crucial to consider changes in correlations and behaviour that are associated with financial innovation and regulation changes. We need to ask how relevant are the pre-innovation or pre-regulatory reform data for assessing impacts? How do these changes affect interconnections and vulnerabilities to a common shock? What are the incentives to “offset" regulatory changes, for example the private production of seemingly “safe" assets that can reduce rather than increase soundness of the system?

Again, no rational agent is arguing against the necessity for regulatory reform. The FSB is alert to the challenge and has an emerging market forum to address the issues. The critical balance is not to stop regulatory reform but to properly understand and measure its impact.

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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