Smart regulations should remain local

The financial sector is unique, and requires special regulatory treatment, according to a report from the Conference Board of Canada.

The financial industry is the only sector to which every participant in the economy is exposed, be they consumers or businesses. And while the financial sector facilitates the exchange of capital, its real currency is confidence.

To ensure this confidence, the industry needs new “smart” regulations according to the report’s authors, Louis Thériault and Michael Burt.

“The rapidly cascading sequence of events that followed the bankruptcy of Lehman Brothers in September 2008 not only reinforced the fact that the financial sector is a cornerstone for every other part of the economy, but also that business and consumer confidence are the cornerstones of the financial system,” Thériault and Burt write.

“The regulatory frameworks for the global and national financial systems need a careful and in-depth review and adjustment.”

The crisis of confidence shook the industry to its core, and the authors say there’s little danger in the near term that “obscure financial instruments and high financial leverage once again become the norm.”

But while current industry players have learned a painful lesson about the interconnectedness of the banking sector, memories can be short, and the next generation of financiers could make similar mistakes.

“Fundamental rules governing the financial system will have to change in order to prevent this situation from happening again in the future,” Thériault and Burt write. “Along with the knowledge that the financial system is vital to a market-based economy — and therefore different than other sectors — comes the need to ensure the system is operated in a responsible way that serves a wider interest.”

Given that securitized debt was at the heart of the financial freeze-up of 2008, it would be easy for regulators and policy makers to target the practice. Public support would be immense, but barring securitization outright would be a mistake, the authors write. New regulations should focus on transparency of securitized debt products.

Historically, securitizing debt has served the economy well by spreading risk and freeing up credit. A better solution would be to increase the capital requirements “to better represent the real risk underlying various securities.”

At the same time, firms should undertake more thorough due diligence and issuers should maintain a larger ongoing exposure to their own products, so they would share the risk they had created.

The authors call for greater reform of compensation within the financial sector, pointing out that bonuses are too often tied to short-term performance. This provides an incentive to take on additional risk, which is borne by the firm, rather than the risk-taking employee.

Because financial firms are so intertwined with the overall economy, these risks threaten chaos outside of the firm. A better model would be to base compensation on long-term performance, rewarding behaviour that stabilizes the firm and, in turn, the economic cycle.

While there have been calls for transnational regulation of financial services, the report’s authors suggest stronger regulation at the local level would better contain crises before they can affect other economies. A global regulator might not take notice of a brewing crisis so long as it remains local, allowing it to build into a transnational problem.

“Reaching a consensus among even the major players in international finance could be near impossible,” Thériault and Burt point out. “Instead, broad principles regarding minimum standards and best practices need to be adopted, with the specifics left to individual countries.”

Among the principles that must be applied, they recommend:

• correcting market failures should be done with minimum intervention; • a list of priorities for action must be drawn up (since not all market failures are equally important) • the long-term implications of any changes must be fully understood.

“Canada was fortunate to avoid the worst of the financial crisis, and should take advantage of its credibility in international financial circles by demonstrating leadership in adopting change,” they suggest. “The best way to do this is to keep working with other major countries and international bodies such as the IMF to improve policy coordination, refine early warning systems, and address policy weaknesses.”

(01/20/10)