“A wild dream: Smart financial regulation”
Claude Bébéar, Honorary Chairman of the AXA Groupe,
Founder and Chairman of the Institut Montaigne,
Interview for the ParisTech Review
Increasing the transparency and regulation of financial markets, especially agricultural commodity markets, is becoming an imperative for an ever-greater number of governments and organizations. The Swiss Federal Council recently published a report on regulation of Swiss commodities. In addition, a new regulatory framework for banks––the Basel III Agreement––will go into effect in 2014. It aims to increase the banks’ ratio of own equity and endorses the concept of improved oversight of OTC derivatives markets.
We highly recommend the interview1 given by Claude Bébéar, Honorary Chairman of the AXA Groupe, Founder and Chairman of the Institut Montaigne, to the ParisTech Review, and are publishing some excerpts below.
During the interview, Claude Bébéar outlines the difficulty of implementing efficient regulation in a context of globalization at a time when, he argues, regulators seem to be disconnected from market realities.
In order to regulate excessive speculation in agricultural commodity markets, so as to curb its adverse effects while preserving the interest it provides in terms of risk transfers and cash flows, we must guard against any normative obsession and recognize the structural shortcomings inherent to these markets.
momagri believes that smart market regulation is the central foundation for development, growth and food security. Therefore, the time has come to propose regulatory systems to correct market excesses and expand the benefits from international trade liberalization.
momagri Editorial Board
Since 2008 and the fall of Lehman Brothers, worldwide efforts have been undertaken to provide a more stringent oversight of financial operations, curb leverage effects and increase banks’ own equity, but all this was achieved without genuine cohesion and with massive differences between nations. Specifically, the implementation of the 2012 new prudential banking regulation––Basel III––has been indefinitely postponed by the United States. Hence, is it back to square one for global finance?
Where do we stand regarding the finance regulation movement?
It is important to bear in mind, at the outset, that the scope of the financial crisis we experienced starting in 2008 has justified greater financial regulation. Significant advances were achieved––better alignment of capital weightings against risks taken by financial institutions, improvement of oversight systems in Europe, among others.
But as finance has become completely international, regulation is extremely difficult to develop and, most of all, implement if it is not entirely global. And crafting a truly global financial regulation has become mission impossible. The new “Basel III” banking norms are an example. Americans announced they would not implement them in the foreseeable future. Under such circumstances, if a bank accepts to respect the Basel III restrictions, it puts itself into a competitive disadvantage compared to American banks. A similar problem is emerging for “Solvency II”, the new insurance regulatory requirements.
If American banks do not implement Basel II, will they really gain a benefit or will they rather trigger mistrust among economic players?
It is not cynical to state that they will gain a substantial benefit. In today’s world of shareholders, what is important is value. Financial players generally feel that regulators take superfluous and excessive precautions. Less capitalized banks will thus be ideally suited to investors and borrowers. Virtue will not pay, because such virtue is wrongly assessed and poorly formulated by regulators who are not competent.
If regulators are incompetent, what is the intermediary driving force to stabilize the financial system?
Regulators are accountants who do have a sense of the vitality of organizations and companies. They have a too static and superficial picture. An under-capitalized company may very well have very developed human resources and strong marketing potential, while another that is well-capitalized in view of prudential standards, might collapse due to a wrong strategy. Actually, regulators are only considering the apparent capitalization. What are really at stake are the real capitalization, the leaders and the capability. Investors are better prepared. They know how to detect and analyze a company’s characteristics that are important for them according to their investment expected lifespan. And regulators are not successful in containing hazards, since they draw upon debatable assumptions whose validity is not constant over time. The environment can change abruptly and make these assumptions obsolete.
Must we restore a kind of Glass-Steagall Act, the 1933 American law that prohibited deposit banks from also conducting investment activities?
Breaking up the “classical” credit business from more speculative activities is a good idea that is consistent with more security. But there again, if there is no similar regulation throughout the world, competition will be highly distorted. One will end up in the more lenient countries to carry out various transactions.
Before going into details regarding the measures to be implemented, we must recognize the root of evil. Speculation is the basic enemy of the economy. Yet all current accounting regulations focus on the short-term, and therefore encourage speculation.
Is it not better to have flawed regulation than no regulation at all?
Unfortunately, regulators are always protecting the system from the previous turmoil. This is the Maginot Line syndrome. In the United States in the late 1980s, we lived through the junk bond––or toxic bond––crisis mixed with a housing slump. Regulators suddenly forced insurance companies to suddenly reduce by 30 percent the estimated value of their shares and properties, under the pretext that insurers are investing over the long-term. The decision lifted the wheels of investment funds, which then started to acquire large numbers of the properties and shares abandoned by insurers. The funds were authorized to proceed with “mark to market” accounting practices, since they were dealing with short-term investors. This is precisely a case where regulators largely contributed to the next crisis, since they handed over shares and properties to speculators, whereas insurers would have given greater stability to such asset classes. On the grounds of containing the speculative danger, regulators replaced savvy and prudent investors by… speculators.
Did they then generate the next crisis, which occurred in the 2000s?
The cause of the 2008 financial crisis is a financial regulation system based on an incoherent and inconsistent rationale that magnified the errors made by excluding from its scope the riskiest markets expanding in unregulated areas, in circumvention of existing regulations. The Basel agreements aimed to implement prudential regulations for banking activities through better risk controls. Banks claimed to eliminate risks by a securitization process that spread them in unregulated financial markets and with unregulated operators.
Banks took over the risk by financing unregulated operators and transactions with multi-level and high leverage effects. The risk thus became too complex for a genuine assessment, and lost all traceability. It thus became more concentrated and re-entered banking activities. Regulators then let such risks to remain hidden by allowing structure investment vehicles.
Might it be impossible to manage global finance?
Today, the genuine risk is excessive and inadequate regulation, an aftermath of thin-skinned legislative responses. Drowning financial institution in an ocean of useless and costly procedures will not avert danger, and will only lead to tightening credit. There is no miraculous and ultimate martingale. Regulation must evolve and tailor its action from the standpoint of the situations. On a case-by-case basis. When the environment is in a state of turmoil, one must adopt even more precautionary measures, since official regulation does not reflect such required flexibility.
If we eliminate all oversight, is the financial system able to self-regulate?
We need common-sense rules, but we must be suspicious of a false sense of security brought about by normative obsession. The issue is managing bubbles without curbing growth. How can a “global” firm owning assets and liabilities in every country––whether it is developed, emerging or developing nations––organize its global accounting practices?
Following each crisis, regulators tend to impose new norms that generate the next crisis. In 2013, can we already imagine what the next crisis will be?
The subprime mortgage crisis––basically the result of President Clinton’s decision in the 1990s to let every American to buy a house––erupted ten years later when the real estate market, which was backed by toxic financial assets, collapsed. Consequently, the world was left with both huge amounts of money that could not be invested in these prohibited products and interest rates that were reduced to very low levels by financial authorities to spur recovery. These represent ideal conditions to breed irresponsible behaviors. As they no longer face monetary risks, players are therefore searching elsewhere for these risks and their related yields. This has led to the development here and there of real estate bubbles that will collapse sooner or later. As money moves without restrictions, when one tries to deal with a crisis in a given country, one creates the conditions for a new crisis in another country. This is the paradox of regulation.
Since it is impossible to prevent crisis, must we attend to them?
Every economist’s dream is finding the tool to dodge all crises. But this is a wild dream. The only sensible method is anticipating crises, when their first signs can be detected. Immediately alter the rules in order to burst the emerging bubble, instead of believing that we can prevent the bubble from forming. But the truth is really that crises are unavoidable.