27 Sep 2022
Historically, regulation has tended to be reactive not pro-active. Central banking and its consequent regulation didn’t emerge until there’d been a series of economic crises. Regulation of fees around payment card transactions didn’t emerge until these payments became a significant part of the economy.
On the one hand, governments and regulators don’t want to act pre-emptively in case that stifles innovation and emerging competition – or indeed uses up scarce resources which would be better devoted to more immediate risks.
“The ‘de-integration’ of banking services … is likely to accelerate and expand until there is a severe problem or even a crisis.” - Michael Hsu, US Acting Comptroller of the Currency
But on the other hand, reacting too slowly in developing a regulatory regime can enable activity resulting in consumer or corporate losses, illicit activity or indeed systemic crises.
It’s a fine balance but with the emerging world of the Metaverse and decentralised finance (De-Fi), crypto assets, artificial intelligence and unregulated competition in regulated spaces, that balancing act is becoming more fraught.
The tension is far from exclusive to financial services. Take the gig economy – how do governments regulate the balance between convenience, lower costs and new services against worker and consumer safety, welfare and predatory competition?
But in financial services the danger of getting the balance wrong can be catastrophic. The 2008 financial crisis, the aftershocks of which continue to reverberate, was largely attributable to lax regulation and supervision of market players creating complex instruments which both camouflaged risk and distributed it to participants least able to carry the cost of failure.
It was a classic case of the fruits of success being privatised and the costs of failure socialised.
Yet financial services are also, on any broad economic analysis, beset by high barriers to entry, oligopoly power and the rents of incumbency.
In one of the most widely cited analyses, the Brookings Institute found “financial services remain expensive and financial innovations have not delivered significant benefits to consumers. Finance does innovate, of course, but its innovations are often motivated by rent seeking and because entry and competition in many areas of finance have been limited.”
Indeed, the unit cost of production in financial services has barely changed in more than a century, prima facie evidence for the failure of innovation and financial deepening to deliver economy-wide benefit.
But again the challenge for government sand regulators is how to address that challenge without – as happened in the financial crisis – exposing the whole system to catastrophic failure. For which taxpayers then must foot the bill.
This debate is increasingly urgent as the realms from which potential innovation – and consequent risk – is emerging are becoming far more disparate, both in the quantity of new competition and the kind competitors.
During the last financial crisis, the major players, by and large, were known entities – banks, hedge funds, insurers, market makers. In recent history, non-bank competition – whether it has been from retailers, telcos, tech companies, industrial companies or wherever – has not been a systemic threat.
But with the emergence of huge technology companies – bigtech – revolutionary fintechs, neo-banks and non-traditional funding sources such as private capital (at least in terms of its current scale) systemic threats are possible.
Already in China so-called “everything apps”, notably WeChat, which enclose almost all of a customer’s activities from social networking to state interaction to commerce to financial services, have emerged. Elon Musk has tweeted that’s what he aspires to with his acquisition of Twitter which would be “an accelerant to creating X, the everything app."
Little wonder financial services regulators are sitting up. In a recent paper “Safeguarding Trust in Banking: An Update”, Michael Hsu, the US Acting Comptroller of the Currency, articulated the risk.
“The growth of the fintech industry, of banking-as-a-service (BaaS), and of big tech forays into payments and lending is changing banking, and its risk profile, in profound ways,” he argued.
“The ‘de-integration’ of banking services that is taking place now has its roots in technology, data, and operations and is affecting all banks, not just the large, money centre banks. My strong sense is that this process, if left to its own devices, is likely to accelerate and expand until there is a severe problem or even a crisis.”
According to the global banking regulator, the Bank for International Settlements (BIS), there are different dimensions to the systemic risks – including for central banks. For example, in a recent research paper, the BIS found “central banks deem the potential losses from a systemically relevant cyber attack in the financial sector to be large, especially if it targets a big tech providing critical cloud infrastructures.”
So who would be regulated in this case? The central bank or the big tech?
The growing universe of risks facing the financial system together with, and often amplified by, the networked nature of modern communication means not only is risk more complex but regulators are acting more precipitously.
Take big tech, for example. The BIS has just released an analysis which lays out its concerns comprehensively.
“In the case of big techs, most of the risks arise from their ability to leverage on a common infrastructure – notably large amounts of client data – that helps them gain a competitive advantage in a wide variety of non-financial and financial services and create substantial network externalities,” the paper said.
“Big tech business models entail complex interdependences between commercial and financial activities and can lead to an excessive concentration in the provision of both financial services to the public and technology services to financial institutions; consequently, big techs could pose a threat to financial stability in some situations.”
Then to the point: “The challenges that this specific business model pose for society cannot be fully addressed by the current (mostly sectoral) regulatory requirements.”
The BIS sees two specific regulatory approaches: “The first is segregation, which is a structural approach that seeks to minimise risks arising from group interdependencies between financial and non-financial activities by imposing specific ring-fencing rules.
“An alternative approach to segregation is inclusion, which consists in creating a new regulatory category for big tech groups with significant financial activities. Regulatory requirements would be imposed for the group as a whole, including the big tech parent.”
Other regulators, including in Australia, are seeking to understand the inter-related risks across regulated entities and the expanding universe of their non-regulated partners, suppliers and network providers.
In another example, the International Monetary Fund is considering what regulatory models might apply to the really non-traditional world of DeFi and crypto.
“Entities operating in financial markets are typically authorised to undertake specified activities under specified conditions and defined scope,” the IMF said in a paper on regulating crypto assets.
“But the associated governance, prudence, and fiduciary responsibilities do not easily carry over to participants who may be hard to identify because of the underlying technology or who may sometimes play a casual or voluntary role in the system.”
How these regulatory agendas will unfurl will, ironically, become one of the key risks participants in the financial system – traditional and non-traditional – will have to navigate. And the over-riding lesson from regulatory history is someone will pay for it – and if the risk takers don’t, we all will.
Andrew Cornell is Managing Editor of bluenotes
The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.
27 Sep 2022
29 Sep 2022