Financial regulation: winning the battle and the war; but what about the future?

July 16, 2012

In the EACT we have for nearly three years campaigned vigorously against some of the impact for corporate participants in the financial system of the regulatory reform agenda. We referred to ‘unintended consequences’ for the ‘real economy’ long before those two phrases started to become the common currency of discussion about financial regulation.

We focused first on the regulation of derivatives (EMIR) and then on the implementation of Basel III through the EU’s CRD IV and CRR proposals. With our limited (and volunteer) resources we have also been trying to influence the MiFID II and MiFIR proposals as well as those for the further regulation of the credit rating agencies, CRA III.

On derivatives we argued from the outset that the push to standardise and force transactions onto exchanges and central clearing would place impossible liquidity risk demands on corporates, reduce the incentives to use derivatives to mitigate business risk and introduce further volatility into the global economy. We also stressed that there is no evidence that corporate use of derivatives directly gives rise to systemic risk within the financial system. The crude G20 proposals needed reassessment and under EMIR and Dodd-Frank that was achieved.

The debate then rapidly shifted for us onto the consequences of Basel III; put in its simplest form, the level of CVA included within the Basel proposals would have had the effect of making those very derivatives that had been ‘saved’ for corporates through the battle on EMIR and Dodd-Frank economically unattractive, because of the level of credit charge that would be included. Within Europe our push for some modification to the CVA assumptions within Basel III has led to the European Parliament supporting the proposition that there should in effect be a read-across from the EMIR exemption to the application of CVA under CRD IV/CRR. Whilst nothing is certain at present in Brussels we are reasonably confident that such an exemption from CVA could survive the trialogue process.

So we won the battle (creating the EMIR exemption) and may even win the war (protecting the economic value of the EMIR exemption from the CVA impact in CRD IV/CRR). But where does this leave us in the wider context of a global financial system about which we should be hugely concerned? It is perhaps worth putting down a few markers against which subsequent events can be assessed:

• There will continue to be pressure to shift derivative transactions onto exchanges. My impression is that however cogent were the arguments we and others made for the exemption, the supervisory authorities still don’t ‘get’ why corporates (non-financial end users) are different from the financial players within the financial system. I have argued elsewhere that this is partly because of regulatory capture.
• Corporates are faced with a banking system that is under siege. Credit risks associated with banks are such that many corporates struggle to manage their exposure and (as a non executive director) I see organisations with which I am involved having to debate relaxing their standards or keeping cash under the corporate mattress or its equivalent.
• Bank balance sheets are under pressure and this will only become worse as regulatory initiatives require that increasing amounts of capital are held to support unchanging or reducing levels of business.
• The failure to resolve the Eurozone crisis translates into further uncertainties over the solvency of those banks that would be impacted by radical structural change, as a result of one or more of the seriously credible scenarios for Eurozone disruption.
• The LIBOR ‘crisis’ looks increasingly like the latest and most serious challenge to the view that banks act responsibly – and that their senior management are indeed ‘fit and proper’ to continue to run institutions combining retail, commercial and investment banking with trading.

The campaign to protect the real economy users of derivatives from the ill-considered G20 regulatory instruction to policymakers was right and necessary. It is therefore logical that we should continue to push for the modification to Basel III that will preserve the value of the EMIR and Dodd-Frank exemptions.

But as we look beyond the crisis – and the resultant huge strain that we currently observe on both the financial system and its regulators – what type of financial system is in the interests of the real economy? The structure and the values needed are fairly obvious:

• market risk and return transparency in all financial instruments;
• credit risk transparency for all derivatives’ counterparties;
• stability and effectiveness in regulatory oversight;
• credible market and credit controls within banks (no surprises….); and
• honesty and trust in the marketing of financial instruments (no bundling…).

Will the banking system deliver what the real economy needs? That brings me back to the question I posed above: the battle and the war may be in our pockets but what about the future?

I see a world in which banks will be forced (rightly) to go through major change by splitting out activities that cannot be combined within one overall entity and splitting the marketing of financial products, so that each product is bought by end users based on its merits. So farewell to the proprietary trading that must be underwritten by a combination of traditional retail and commercial banking or the taxpayer or the shareholders (assume any combination of that you consider realistic) and farewell to bundling designed to obfuscate financial transaction costs.

I also see great risk in even getting the banks to the position where they can implement the changes that politicians, regulators and society will demand. Some banks will buckle under the combination of capital requirements and Eurozone change.

And I of course see profound ‘forced’ deleveraging of bank balance sheets notwithstanding all the underlying arguments for economic stimulus that will also be seen as pressing.

Corporates will want to look beyond the traditional financial system for their counterparties – these do not necessarily need to be restricted to financial institutions. Just as individuals and very small businesses have already responded to the opportunity to engage peer-to-peer, corporates and pension funds should engage more directly with each other for both funding and hedging.

The battle over derivatives will therefore be increasingly irrelevant in the longer term. The global financial supervisors will undoubtedly try to erode the exemptions, as these do not ‘fit’ with their view of the world (regulatory capture?). End users in the real economy need to think ahead to the continuation of a flawed and fragile financial system and consider how they can reduce their dependence on it. We need a financial system less dependent on the financial institutions. Such a system would probably be less liquid (so it may not be possible to implement a hedging strategy in seconds) but it would certainly have lower systemic risk: the failure of a counterparty would only affect the other counterparty rather than the financial institutions.

One Response to “Financial regulation: winning the battle and the war; but what about the future?”

  1. Interesting comments Richard! I fully agree with you. I keep thinking it won’t be a battle but series of battles, or even a long war we treasurers will have to face and to resist to preserve our interests which sometimes are not compatible with those of bankers. Our profession and function will keep evolving in the coming years because of these regulations. You mention some possible (new) routes or ways to react. At least we will live interesting moments and challenging situations. Our flexibility and adaptibility will be tow essential qualities of modern treasurers I guess. Thanks for these excellent comments! FM.

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