Sunday, March 29, 2009

More on financial market regulation

Mathias Dewatripont, Xavier Freixas, and Richard Portes of the CEPR have compiled an excellent e-book that analyzes a range of policy proposals for how the G20 process and the London Summit might bring about concrete, implementable results that can restore confidence and lead the way to recovery.

It concludes that while the ongoing banking crisis is no different from other systemic crises, its uniqueness "comes from the specifics of the macroeconomic fragility and the channels of contagion which are to some extent unprecedented". The global nature of the crisis, involving developed, emerging and poor countries, means that any solution should involve "reciprocal commitments and actions".

It attributes the sudden transformation from markets that were (thought to be) perfectly transparent and efficient to complete opacity (similar to an Akerlof adverse selection market in lemons with its no-trade equilibrium) and rigidity to "the complexity of instruments, the increased risk of the collateral on which the securities were based, the failure of credit rating institutions to perform properly, and the lack of adequate countercyclical prudential regulation".

It finds that "three key factors combined to trigger the regime switch - liquidity shortages that occurred, despite generous liquidity injections by central banks all over the world; the buildup of huge portfolios of credit default swaps (CDS) in a small number of institutions that suddenly became vulnerable with the onset of the crisis; and the collapse of credit ratings awarded to structured securities as a basis for valuing and trading these securities". The other factors included, "the procyclical bias of Basel II regulation; the lack of a proper system for dealing quickly with insolvent banks; and the tendency of bank compensation systems to encourage excessive risk taking by employees, coupled with poor corporate governance and the failure of shareholders to act to protect their investments".

The report argues that "neither monetary nor fiscal policies will work unless and until the blockages in the supply of credit are resolved. Financial intermediation and the structure supporting it must be restored to near-normal conditions to stop the accelerating decline". It makes the following recommendations for achieving this

1. Address global imbalances and capital flows
a) Create credible insurance mechanisms for countries that forego further reserve accumulation and stimulate domestic expansion, along three possible lines - more central bank swap lines; ’reserve pooling’; and an expansion of IMF resources - together with IMF emphasis on a large, flexible, fast-disbursing facility that would come with little or no conditionality to countries that are adversely affected by global shocks. Large loans to the IMF by major reserve holders offer one way of funding this insurance until Fund quotas are raised, as they must be.
b) Accelerate the development of emerging market country financial systems, with particular emphasis on local currency bond markets and on foreign currency hedging instruments. Promote regional cooperation in the design of common institutional standards for financial market development and work to lift barriers to cross-border asset trade within regions.

2. The challenges of macroeconomic policy in the crisis
a) Meet any threat of deflation promptly, before it takes hold, with a zero interest rate policy (ZIRP) and quantitative easing. Establishing an inflation target may help to avoid expectations of deflation.
b) A global ZIRP would raise a particular problem: not all countries can benefit from the stimulus of exchange-rate depreciation. A country with large trade surpluses with positive GDP growth should refrain from intervention to prevent appreciation, which would be a beggar-thy-neighbour policy.
c) International coordination of cooperatively designed fiscal stimuli is necessary to allow the internalisation of the effective demand externalities of a fiscal stimulus through the trade balance and the real exchange rate. Fiscal stimuli should follow the ’fiscal spare capacity’ of each country, i.e., its ability to generate larger future primary government surpluses.

3. Macro-prudential regulation
a) Mitigate procyclicality (of the Basel II regulations) by adjusting the Basel II capital requirements using a simple multiplier that depends on the deviation of the rate of growth of GDP with respect to its long-run average. Specifically, the requirements would be increased in expansions (or decreased in recessions) by some percentage points for a one standard deviation change in GDP growth, and thereby provide adequate buffers that will limit the procyclical effect of prudential regulation.

4. Market reforms
a) Require without further delay a centralized clearing counterparty for CDS trades. Consider going further to require that CDS be exchange traded and consider prohibiting CDS that do not insure a holder of the underlying asset (naked CDS).
b) Require that credit rating agencies (CRAs) be paid if possible by investors rather than by issuers, or at least that the link between CRAs and the issuer is severed, so that a CRA’s rating does not affect its future business with a given client. Also, for structured instruments, force greater disclosure of information about the underlying pool of securities. Prohibit indirect payments by issuers to CRAs in the form of the purchase of consulting or pre-rating services. Consider an open access, non-prescriptive approach by regulators, eliminating the NRSRO designation and the extensive ’hard wiring’ of the CRAs in the regulatory system.

5. Controlling financial institutions
a) Establish a harmonized special bankruptcy regime for banks. This would involve US style "prompt corrective action", giving the (independent and well-staffed) supervisory agency powers to limit the freedom of bank managers (possibly remove them) and shareholders (possibly expropriate them) before the bank is technically insolvent.
b) Consider the creation of an International Financial Stability Fund that takes equity positions in the financial institutions of participating countries and monitors their activities.

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