FT research prize 2012/2013 – winning essay

November 12 2012

International Financial Supervisory Convergence – Building the architecture to win the next war and not to fight the battle already lost

Overview – radical action is needed

Thomas Jefferson, the US President, in a letter to John Taylor in 1816 wrote:

“And I sincerely believe, with you, that banking establishments are more dangerous than standing armies; and that the principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale.”

That was written in a much simpler world. Rolling forward almost 200 years, in a more globalised and interconnected world, the power of banking to be “dangerous” is even greater and there for all of us to see.

In fact, another US President, no less than the present one, President Obama, summed it up. A recent book (“The Obamians” by James Mann”) quotes the President as follows:

“Shortly after his inauguration as president, Barack Obama was given a briefing by the CIA about the danger of Pakistani nuclear weapons falling into the hands of nuclear terrorists. ‘That’s scary’ said Obama, ‘but in the meeting I had before this one, the Treasury told me that every bank could fail before the end of the month. Now that’s really scary”.

A bit of fear is always healthy to drive the right perspective and actions. In addressing how we rebuild the global financial sector and design a fit for purpose international supervisory framework, we need to realise the great costs of getting it wrong. It will drive us to be radical.

In our increasingly interconnected and fast changing global economy, an effective international financial regulatory framework must be flexible and dynamic enough to anticipate and manage risks we do not yet understand, using technology not yet invented to deal with financial crises that have not yet arisen. It must also be simple and transparent and must not seek to impose complex rules based control. Instead, regulators should exercise their judgment in ways which allow them to take into account an array of financial, psychological and behavioural factors. At the same time, regulators must respect and be seen to respect the sovereignty of national governments.

The quality and conduct of the regulators themselves will of course be critical. Remuneration packages should be very generous whilst the penalties for fraud or criminal negligence should be correspondingly harsh.

We believe the international financial regulatory framework proposed must tick all of these boxes and is the most effective way of promoting and maintaining systemic stability to the global financial system for several years to come.

The stakes of getting it right, or wrong, have never been higher.

The focus should be on the globally significant international financial institutions (Gsifis)

The financial system is already so globally interconnected that the failures of individual major institutions will always have a negative impact on the rest of the global financial system with potentially disastrous consequences for individual economies. Whilst the worst consequences can be averted through intervention by governments, this can be extremely costly to taxpayers. Therefore regulation inevitably must take place at a global level. The question is, however, how do you implement a global regulatory system which effectively takes account of local economic idiosyncrasies and practices and respects the independence of sovereign governments?

Focusing regulation on the Gsifis is the answer. This would allow for global consistency in rules and application among major players without the need for active intervention in the regulation of banks in individual sovereign states. Yet the effects of the regulation of the Gsifis will be felt by branches in individual countries. Without any real or perceived rules based “heavy handedness”, the effect should be to “nudge” individual countries’ banking sectors to fall in line with the spirit of the international financial regulatory system.

International supervision must strive for simplicity

An international regulatory system can only promote systemic stability over the longer term if it is capable of protecting consumers ranging from unsophisticated individuals to highly experienced analysts and advisers. It has to deal realistically with the fact that high levels of financial illiteracy exist and will continue to exist for some time to come throughout all societies. Complexity and lack of transparency were significant contributors to the last financial crisis. Complex regulation is undesirable as it will only encourage increased levels of complexity within the financial system itself. Not only must the regulation be readily understood and transparent, but it must also be such that the Gsifis consider it to be in their interests to adopt systems and products which are less complex and easier to understand.

For example, Transparency International’s Corruption Perception Index is a relatively simple system which is widely understood and respected. Indices or measurements based on these principles have the knock on effect of encouraging greater simplicity and transparency of processes and products within the firms themselves.

The case for a “judgment” rather than rules-based approach

Any effective global financial regulatory system must be designed to anticipate and manage crises. It is not possible to anticipate and define future states of the world, and to prescribe rules which effectively manage the risks. In our fast changing world, our cognitive limits are quickly breached. Regulators need a robust system which is sufficiently dynamic to analyse and manage risks we do not yet understand, using technology not yet invented to solve financial crises we do not yet have. Only a relatively simple judgment based framework rather than a precise rules based framework will allow for this.

The framework – The Seven “C”s for global financial sector health

If banks are potentially more powerful than weapons of mass destruction, international regulators need to see themselves almost as the banking equivalent of the International Atomic Energy Agency (IAEA).

Representatives from each of the G20 countries should be appointed to a panel of international financial regulators. The Financial Stability Board already has the seeds of this. However, its remit should be made sharper. It should keep the focus on Gsifis.

This supervision should not be by way of a complex, rules based system. Instead, the regulators should exercise their judgment in ways which take account of an array of financial, psychological and behavioural factors. A focus on just capital is not enough.

The regulatory framework is described below. We then set out the arguments for key aspects of this proposal.

Global Financial Stability Insurance Fund

All GSifis should be required to contribute an amount to a Global Financial Stability Insurance Fund which would be utilised to stabilise the financial markets in the event of future crises. There can be no repeat of our previous collective failure to see the build up of risks and to only take action in the aftermath of the financial crisis. We have to expect and prepare for future crises and an insurance fund established by the Gsifis will help to do just that.

The amount that each Gsifi contributes should be determined on the basis of an overall score awarded by the Gsifi regulators under the proposed the “7Cs” Gsifis Perceptions Indices.

The proposed Gsifis 7 Cs Indices provides an ideal judgment based framework which will allow for robust and effective decision making in anticipation of or in the midst of crises.

Each year, the regulators should determine and score individual Gsifis on the basis of the “7Cs indices” referred to below in light of how they are perceived by analysts, business people and experts in countries around the world. These 7Cs Perception Indices and how they could be modelled are summarised below.

1. Capital – how well capitalised is the institution, under normal conditions and under stress? for this regulators should use the proposed FSB framework for capital; the FSB should take over the stress testing of the G-SIFIs and publish the results.

2. Conduct – how fair and equitable are their business and employment practices of the firm perceived to be; there should be assessed by metrics such as lending into lower-income sectors of the communities in which the firms operate, consumer surveys in major markets, and the level of fines paid.

3. Complexity – how transparent and easily understood are their operations? Recovery and Resolution Plans should be assessed by way of quality by the FSB and a public score given.

4. Capability – how efficient and technically competent are their management and staff perceived to be? How gender and ethnically diverse are its management cadre? Firms should be made to publish these profiles and ranked for degree of d. You cannot run a global bank successfully if its team does not understand the world in which it operates.

5. Corporate Social Responsibility – how is the firm contributing to the global and national economies? How much is it contributing by way of taxes, dividends and investment in its CSR programmes per capita in each economy and overall where they operate? This should be measured and published with the understanding that this number should be positive.

6. Connectivity – how interconnected is the firm globally in facilitating global trade and productive global financial services?

7. Corruption – how honest and incorruptible are their operations perceived to be; this can be derived from sources such as Interpol, the FATF and Transparency International.

Capital is important, yes. Its weighting should be 40% within the framework. The other “C”s should contribute 10% each to the overall assessment. The overriding message is that to properly supervise the global financial system and the significant institutions within it, we need to look at these wider set of characteristics which determine whether a financial institution will be sustainable in the future.

International supervisors must be the best and the brightest – appointment/remuneration of regulators

The central bank of each of the G20 countries should appoint an appropriately qualified and experienced person to the panel of Gsifi regulators. Every effort should be made to ensure that the regulators preserve financial and intellectual independence and can withstand undue pressures from powerful political and financial interests. For these reasons, the remuneration awarded to the regulators should be very benchmarked to appropriately senior executive levels in the private sector.

The central banks of G20 countries should each appoint a regulator to the panel for a minimum of ten years. Guidelines for appointments should be developed with this in mind. Given the seriousness of the role and the potentially disastrous consequences of systemic failures, prospective regulators should be of the highest calibre and should be required to go through a process no less rigorous than that required by potential appointees to the Supreme Court of the United States of America.

A global financial regulatory system can only be as effective as the quality of its regulators and their willingness to preserve their independence. The regulators appointed must therefore be incentivised in practical ways to preserve their independence and objectivity.

The combination of market based compensation packages with harsh penalties in the event of corruption has given rise to effective government and administration with low levels of corruption in countries like Singapore. We should learn from this. Countering the inevitable industry resistance to supervision will require generous remuneration/retirement packages for regulators as well as any further resources and support necessary to counter the inevitable industry resistance to supervision.

The penalties for fraud or criminal negligence by the regulators should be harsh. Such a fundamental breach of their duties should fall under the jurisdiction of the International Criminal Courts in The Hague.

Accountability of international supervision – who guards the guards?

The regulators should be accountable to the central banks of their respective countries and also to a board of advisers appointed by the G20 central banks. This board of advisers should be comprised of appropriately qualified and experienced persons from non G20 countries. [The weight of the votes cast should be commensurate with the size of the respective G20 economies). They should have two roles:

a) The Gsifi regulators should carry out their duties in consultation with the board of advisers.

b) Each year, the board of advisers should also write a report on the perceived effectiveness of the Gsifi regulators and of the regulatory system itself in meeting the long term objective of promoting and maintaining systemic global financial stability.

Again, the remuneration awarded to these advisers should be benchmarked to market in order to preserve their financial and intellectual independence and ensure that they can withstand undue pressures from powerful financial and political interests.

A board of advisers should be appointed by non G20 countries for two reasons. Non G20 countries are also adversely affected by crises in the global financial system and should therefore have a “voice” in regulation. Consequently, G20 regulators should be required to make decisions in consultation with the non G20 board of advisers.

Secondly, central bankers from economies which have experienced relatively long periods of stability over the past few decades are arguably have much to learn from their non G20 emerging market counterparts who have had to manage through considerable turbulence and uncertainty over protracted periods of time. The board of advisers from non G20 countries provides an effective mechanism for the transfer of knowledge and critical advice.

Again the board of advisers must be of the highest calibre and must be incentivised to preserve their independence and objectivity. Guidelines for appointments should be developed with this in mind. The central banks of the G20 countries should cast votes [the weight of these votes should be commensurate with the size of their respective economies]. Given the seriousness of the role and the potentially disastrous consequences of systemic failures, prospective appointments to the board of advisers should be required to go through a process no less rigorous than that required by potential appointees to the Supreme Court of the United States of America.

In the context of international supervision, there should be a mechanism where there is a line of sight established on the work carried out by international supervisors through to national parliaments of countries impacted by their work.

Enforcement – international supervision must have some teeth – The International Criminal Court

Systemic failures to the global financial system wreak havoc on economies, create mass unemployment and cause untold hardship to millions. It is imperative that harsh penalties are in store for those who contribute to such failures through criminal negligence or fraud.

Prosecutions of officers of the GSifis, the GSifi regulators as well as their board of advisers should be brought before the International Court of Justice. This court should have the power to impose long prison sentences, as well as fines, forfeiture of proceeds, property or assets derived directly or indirectly from the crime committed. All such proceeds less costs realised by judicial procedures should be paid in to the Global Financial Stabilisation Insurance Fund.

Radical times need radical actions

Banks need not be dangerous. Indeed, a thriving global economy needs strong global banks, regulated by empowered and accountable international regulators. A framework focusing on the G-SIFIs, informed with simplicity and transparency and shaped by principles and judgment rather than rules must be designed. It should look beyond capital to areas such as conduct, complexity, capability, corporate social responsibility, connectivity and corruption. It must be overseen by capable, well remunerated and accountable regulators. The framework should be given teeth. We need to be radical. The times demand it and our societies and economies deserve no less.

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