Will Financial Regulation Trash Global Economic Security?

Alexander Mirtchev, Contributor

 Under the auspices of the Financial Stability Board, more than 30 recommendations have been set out as part of a massive and far-reaching G-20 financial regulatory reform package to ostensibly minimize risk in the financial system and maximize consumer protection.

(Photo credit: Wikipedia)

The new measures fall into several broad categories, including: 1) surveillance (systemic risk boards) 2) bank capital and liquidity (Basel III standards tightening the rules on the ratio of bank deposits to lending); 3) too big to fail (new thresholds for those designated as Systemically Important Financial Institutions); 4) capital markets (new requirements surrounding OTC derivative activity and the role of credit rating agencies); 5) compensation standards; and 6) reduced opportunities for regulatory arbitrage particularly with regard to the so-called shadow banking system.

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Indeed, the call for increased regulation follows in the wake of every major crisis, and no call was made with more ardor than the call for increasingly tight and comprehensive regulation of the financial sector.

However, answers to important questions remain elusive.  What will be the effect of new regulations on a global economy that has suffered millions of job losses and had trillions of dollars in economic output wiped out?  How will they impact economic growth and global economic security?

Regulations inherently carry both explicit and implicit costs.  Countries and industries across all sectors experience explicit costs, which range from the costs to government of directly administering the regulations to the compliance costs, such as data aggregation, integration and other significant reporting requirements.  However, it is the implicit costs of regulation that are more likely to generate overall negative outcomes and impair economic efficiency and growth, not to mention the inevitable unintended consequences of such regulation.  Indeed, the wild card in the new financial regulatory push is the impact on banks’ customers, whether they are multinationals trying to manage risk or small and medium-sized businesses trying to access credit for business expansion or trade financing.

A study undertaken by the Institute of International Finance, which represents private banks from around the world concludes “that all the measures combined…could push bank lending rates up by over 3 ½ percentage points on average for the next five years.  The result could be 3.2 percent lower output by 2015 in these economies than would otherwise be the case.  This would lead to about 7.5 million fewer jobs being created.”

Josef Ackermann (Photo credit: Wikipedia)

Dr. Josef Ackermann, chairman of the IIF Board of Directors, chairman of the Management Board and the Group Executive Committee, Deutsche Bank AG stressed that, “Against this background and in light of the IIF’s projections, it is critically important that the macro-economic impact of additional regulatory measures under discussion, as well as the impact of approaches to implement measures already taken, be a major consideration for governments and regulatory authorities.”

Furthermore, the advances in communication and financial services could allow the emergence of new and sometimes even more exotic approaches and products that obviate the newly imposed regulations, as there is a long history this occurring.

These concerns should be carefully weighed and addressed.  That is not to say that, given 21^st century economic and political realities, reform of the financial regulatory system is not warranted.  The issue is not whether or not to regulate, but what to regulate and how to reinforce, rather than distort market efficiency, promote productivity and growth.

More often than not, the right answer lies in how the question is formulated. Is it not time to cease fighting against the current; or, if you prefer, stop trying to put the genie back in the bottle? The next question is, is it not time to embrace and be guided by the modern times, where financial markets regulation is concerned?

The answer may lie in utilizing the pace of financial advances, the modern technology, communications, knowledge and infrastructure that are already in place, as well as intensifying participation in the financial markets, etc., particularly by the growing middle class.. In short, this answer could entail unleashing a ‘global financial mega-market’ of mass participation, based on new and upcoming technologies, as well as advancements in the financial services sector.

This new mega-market should better empower and incentivize market players and individual consumers to conduct economic activity.  It should place a strong value on societal well-being while at the same time allow markets to seek the most efficient outcomes.

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The regulatory framework should ensure that participants – individuals, corporate and institutional players, etc. – are in possession of the requisite information about the specific financial rights and liabilities, procedures, instruments and products.  This entails regulating the product, not the process or the activities that lead to it, and ensuring that the proper description of the financial market products contains the necessary and precise information that would provide the participants, consumers and regulators with the ability to make a rational choice.

Such an approach would provide a framework that would neither impair efficiency nor neglect regulation. Beyond ensuring accessibility and precision of the financial market products information, the authorities should also ‘educate’ the market participants about the risks, responsibilities, benefits and rights associated with specific financial products or transactions.  These rules about information and education would need to be enforced to ensure market efficiency and avoid abuses.

Although presenting only a glimpse, this brief question indicates how the modern financial realities could evolve. As financial market products are constantly developing, the regulatory target should be to maximize transparency and enforce compliance.  Still, although introducing such a market may create its own problems, it should be capable of addressing systemic risk issues and be conducive to growth. Having the ability to adapt to new and upcoming challenges, such a financial market of mass participation, could prove to be a significant factor in 21^st century global economic security.