Financial regulation: The money moves on - FT

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2010-09-15 10:43

Financial regulation: The money moves on

By Patrick Jenkins and Brooke Masters
Published: September 14 2010 20:11 | Last updated: September 14 2010 20:11

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It took two years to get there, but when international regulators late on Sunday announced the final details of their mammoth overhaul of bank capital and liquidity standards – the so-called Basel III package – there were hopes they were laying to rest the ghost of Lehman Brothers.

Just ahead of Wednesday’s second anniversary of the ignominious Lehman collapse, the Basel Committee on Banking Supervision unveiled a finely-tuned package of reforms – more than tripling capital requirements – to the accompaniment of much back-slapping.

“The combination of a much stronger definition of capital, higher minimum requirements and the introduction of new capital buffers will ensure that banks are better able to withstand periods of economic and financial stress, therefore supporting economic growth,” declared Nout Wellink, the veteran Dutch central bank chief who chairs the committee. The changes “will create a much more resilient banking system in the future”, echoed Lord Turner, head of the UK’s Financial Services Authority. The deal was the key to “a more stable banking system that is less prone to excessive risk-taking”, chorused US regulators.

There have been critics. Initial regulatory proposals have been watered down after industry consultation. Parallel reform proposals from politicians have also been weakened on their way into law. The powerhouses of Wall Street and the City of London lobbied hard to retain their historical sources of high-risk profit in the face of those determined to “de-risk” the system.

But there is real change all the same. The Basel III regime, to be phased in by 2019, comes on top of legal reforms in various parts of the world, notably the US, where the so-called Volcker package implemented via the Dodd-Frank legislation aims to curtail big banks’ risks. Most fundamentally, the practice of pure proprietary trading – whereby banks bet their own money dealing in anything from gold to Greek bonds – is being outlawed in the US within two years.

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In addition, the changes make all forms of trading, particularly “prop” trading, more expensive by forcing banks to hold more capital in reserve to support the activity.

Yet a nagging worry is expressed by some regulators, bankers and other experts within the financial services industry that these reforms, like others in the past, risk backfiring. What if those taboo, high-risk businesses cannot be stopped in their tracks as regulators and politicians would like? What if, instead, they just move to a new home – within the sprawling mass of hedge funds, private equity firms, trading houses, even energy companies, all of which are largely unregulated and free of the capital requirements imposed on the banks?

Few are prepared to talk openly about the issue for fear of seeming disloyal to the campaign for concerted action against the banks but in interviews conducted over several months the Financial Times has pieced together a picture of mounting unease that the focused crackdown on banking could just push risk out of the reach of the toughest regulation and into fast-growing “shadow” areas.

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“I think this is a real risk,” says one influential European bank executive on condition of anonymity. “I don’t buy the argument that if it’s a hedge fund it doesn’t matter because it’s a bunch of rich people’s money and so the government isn’t going to have to bail it out if it fails.” With hedge funds growing far bigger, and being increasingly backed by big pension funds and insurance companies, it can be systemically important whether these funds fail or not. “Who says a hedge fund can’t be a systemic failure? Then you’ve just shifted the problem from the banks to somewhere else where you can’t really get at it.”

There is a pretty powerful precedent for the theory that a “shadow” banking system can cause or compound a crisis. The fall of Lehman, Bear Stearns and other banks around the world in 2008 was made possible because the financial risk that stemmed from the US subprime mortgage lending was being recycled around the market via shadow banking structures. These entities, from money market funds to investment products such as collateralised debt obligations, hid the real risk because they were not properly regulated.

It is impossible to know how another shadow banking market will evolve, but even top regulators suggest lightly supervised non-bank financial services companies could be the next accident waiting to happen.

Senior figures from Jean-Claude Trichet, president of the European Central Bank, down have raised the issue with peers in recent months. “The important thing right now is that we have acted to strengthen bank regulation,” says one central banker. “The biggest danger would have been doing nothing. But, going forward, we as regulators must watch closely how the shadow banking market evolves.”

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The biggest concern probably surrounds the growth of prop-style trading operations within hedge funds and private equity companies. “Private equity and hedge funds could be winners, taking on more risk,” says Kian Abouhossein, banks analyst at JPMorgan. “Through derivatives, for example, you can imagine them taking on very big positions. This is all about risk fragmentation, which could be a good thing. But if you then get risk concentration within hedge funds, that’s the real danger.”

Simon Gleeson, an expert on financial regulation at Clifford Chance, the law firm, is clearer still. “There is a real danger that risk moves out of the regulated system – out of the bit of the industry that regulators can see. Non-banks – funds and insurers, for example – will have a significant cost advantage under the new rules on bank capital. It’s a third more expensive in regulatory capital terms to do business with a bank than with a non-bank. This is a powerful incentive to use non-banks as counterparties.”

Recent months have already brought spin-outs from banks including Goldman Sachs, BNP Paribas and Deutsche Bank as prop traders have set up their own hedge funds. Now, elements within Goldman’s prop team are reportedly weighing a wholesale shift to the likes of Kohlberg Kravis Roberts, the private equity firm, or BlackRock, the fund manager.

Nervousness also exists about the volumes of trading being done within energy companies and other commodity trading houses. Oil companies and trading houses have been steadily extending their reach beyond their traditional focus on physical commodities into exotic over-the-counter derivatives to serve customers, a trend that some expect to accelerate now that their capital advantage over banks is widening sharply.

Oil companies such as Total and BP and traders including Cargill and Vitol are in effect shadow banks for the commodities industry, replicating the services that the likes of Goldman Sachs and Morgan Stanley monopolised for years. That might mean selling an oil swap to an airline or an OTC corn option to a farming group.

Trading and oil company executives see their move towards derivatives as a natural extension of their business, saying the OTC deals help their clients to hedge price risk. But some analysts say the activities, which are largely unregulated, bring big risks to the system. Without the capital requirements imposed on banks, a default becomes more dangerous, they say. The shift also awakens unwelcome memories of Enron, the failed US energy company whose traders severely disrupted the California energy markets in 2000-01 as well as costing investors billions of dollars.

Recently, some trading companies have withdrawn from providing commodities derivatives services to customers after losing large amounts. Japan’s Mitsubishi Corp is to close its oil derivatives business by March 2012. The unit made heavy losses on jet fuel hedges related to the collapse of JAL, the Japanese airline.

Financial regulators typically have oversight of traders and oil companies in this area. But in Europe, in particular, they admit privately that they pay very little attention to them.

What worries some of the world’s more go-ahead regulators is that failing to respond to the potentially counterproductive elements of Basel III would repeat mistakes with predecessor regimes – Basel I and Basel II – which critics say laid the foundations for the latest financial crisis.

“We must be honest about past errors,” says one senior central banker. “We must admit that it was a mistake to relax trading capital requirements in 1996. Equally, it was a mistake in the past not to think about the quality of capital when setting quantity targets.” It was an insufficient supply of top-notch equity within the banks, and a surfeit of lower-quality debt capital that was unable to absorb losses effectively, that allowed the financial crisis to wreak such havoc on the whole system.

Not everyone thinks the world should worry. Paul Volcker and George Soros are among luminaries to have played down the risks to financial stability posed by hedge funds and other non-banks. In any case, limited moves are afoot to improve supervision of them. In the US, the Dodd-Frank legislation makes several efforts to tackle the risks posed by the shadow banking sector. Hedge funds will be required to register and provide information to the Securities and Exchange Commission, giving US regulators far more oversight of such firms than before.

The new Financial Stability Oversight Council also has the power to demand information from non-banks with more than $50bn in assets and it can place such firms under the supervision of the Federal Reserve if it believes they pose a threat to US financial stability.

Nicolas Veron, who follows regulation at the Brussels-based Bruegel Institute, says the US has so far done the best job. “Their vision was to regulate all financial firms, whether they are banks or not,” he says. “In Europe, we are wedded to pigeonholing institutions. The EU has not realised how much risk transfer occurs across different categories of finance that can escape sectoral regulation.”

Some experts say they are particularly concerned that the migration of activities into the shadow sector might make the economy more resistant to central bankers’ efforts to control inflation through monetary policy. Easily available wholesale funding from non-bank sources, for example, may make it easier for a bank to ignore interest rate signals. The Basel committee is trying to tackle this issue through a new liquidity pol icy called the net stable funding ratio, but it has agreed to delay the new rules until at least 2018 because of sharp opposition.

“The debate we must have now is how to delineate clearly the frontiers of regulation,” says Michael Mainelli, an academic and regulatory consultant. “If too many problems arise in shadow banking under the narrow approach, there will be cries for regulatory extension. Too broad an approach leads to sprawling regulation, of variable quality and effectiveness. As problems arise, the regulatory system will lurch from crisis to crisis and wind up extending to cover everything and nothing.”

Whatever the truth about the risks building up in non-banks, one thing is certain: a more joined-up approach to regulatory thinking can only be a good thing, as Paul Tucker, deputy governor of the Bank of England responsible for financial stability, urged in a speech this year. “Banking supervisors cannot sleep safely solely on the basis of their own work,” he said. “The financial stability authorities need to attend to the dynamics of the overall system.”

He was talking predominantly about the causes of the last financial crisis. But his message applies just as powerfully to the next one.

In supervision, as in the mosh pit, ‘any co-ordination is coincidental’

Since the near collapse of the financial system in 2008, regulators and politicians around the globe have been scrambling to tighten supervision and enact a raft of rules that they hope will prevent another crisis, writes Brooke Masters.

The leaders of the Group of 20 industrialised and emerging nations promised in 2009 globally co-ordinated efforts to make banks safer by damping down risk-taking, controlling pay and raising regulatory standards. But the reality has been somewhat different.

While the Basel Committee on Banking Supervision managed to reach a global deal on capital and liquidity standards on Sunday, that has not stopped individual countries and the European Union from going their own ways on everything from remuneration and short selling to the responsibilities of custodian banks that are paid to safeguard funds’ assets.

“The warm words of comfort from the G20 on global responses to global problems are mutating into a nightmarish tangle of fragmented regional and national proposals,” says Bob Penn, a London-based lawyer at Allen & Overy. “All are aimed at the same broad goals but they are complex, vastly different in detail, will progress at different speeds and will have numerous unintended consequences – particularly for international financial institutions.”

The US recently enacted a sweeping set of regulatory reforms known as the Dodd-Frank Act, which includes everything from limits on proprietary trading (taking bets with a bank’s own money rather than for clients) to new consumer protection rules and the creation of a body to monitor and control systemic risk.

The UK has come out with its own liquidity and pay rules, and recently put out a discussion paper suggesting that Basel and regulators worldwide should rethink their approach to capital requirements for trading books. The Swiss enacted tougher capital rules well ahead of the Basel announcement, and the Germans in turn enacted a broader ban on short-selling of financial stocks before anyone else in the EU.

The EU has approved its own pay rules, passed regulations for credit ratings agencies and is working on rules likely to change the way banks create and sell derivatives. Brussels has also created a clutch of pan-European regulators, including one specifically focused on banking. In addition, it is drafting the first EU-wide directive for hedge funds, which includes tough rules for custodian banks.

The situation is akin to the mosh pit at a rock concert, warns regulatory consultant Barbara Matthews. “Everyone shares the same goal amid a frenzy, but any co-ordination that occurs is coincidental, and along the way people can get hurt,” she says. “Folks in a mosh pit have fun until they get hurt. Regulators have fun using their muscle ... until something comes back to bite them.”

Additional reporting by Javier Blas