The Theoretical Roots and Features of the Current Approach to Financial Regulation

History shows that capitalism may be blended with a large variety of political organiza­tions, each summarily representing a different solution given to the public-private part­nership.

The reference to Keynes is not meant to neglect other thinkers who, although in dif­ferent ways, point to similar directions. For example, Henry Calvert Simons and Frank Knight, the guardians of liberal thought in the Chicago of the 1920s, argued that abso­lute economic freedom does not produce competition and social justice and asked for radical structural interventions by the state (Tonveronachi, 1982 and 1990). We may discuss at length policy issues that differentiate liberals like Keynes, Simons and Knight. However, the relevant fact is that they saw the state as the commanding molder of the system because markets do not produce the desired social results when these are defined according to openly stated political liberal principles and not through elegant but purely deductive theoretical propositions that help hide political preanalytical positions.

The latter is the case for the laissez-faire approach, a term that, following Keynes, is preferred to neoliberal or ultraliberal because it has nothing to do with the found­ing principles of liberal thought.² Its mission is to show, or to demonstrate in its jargon, that an anarchic economic system guided by a supernatural invisible hand is the best arrangement for producing a general optimum.³ The eventual role of the state in the economy is to remove or weaken specific man-made imperfections defined in terms of discrepancies with respect to the anarchic model. However, even this supportive role of the state is looked upon with suspicion. The state is presented as full of political moral hazards and a myriad of other imperfections that miraculously disappear when the pri­vate governance of firms and markets collectively guided by the supernatural hand are considered. Following this logic, technical authorities (politically independent but well connected with the markets) should be the right solution.⁴ The fact is that this approach does not pass the test of any reasonable scientific standard, which requires that the model must conform to reality, not vice versa. When uncertainty, money and financial markets are fully considered, the model collapses, but its policy prescriptions continue to be uti­lized “as if” the model were representing the optimal form of economic organization of the real world. Trying to force the real world to partially adapt to the anarchic model can only produce disasters. If these positions were to remain confined to academic circles, we would just sadly observe how much intelligence is being wasted. The problem is that for a variety of reasons, some of which are discussed in the next section, this approach is the (often covert) dominant foundation of economic policies. Financial regulation is a case in point.

Global finance requires the international harmonization of minimum regulatory and supervisory standards, the so-called regulatory level playing field.

How does this apparently simple approach account for the increasingly complex, costly and ineffectual financial regulation and supervision, especially in the banking industry? The answer is, because interventions made according to the chosen representa­tion of reality have produced an increasing disparity between desired and actual results. As occurred with the Ptolemaic cosmological theory, the attempt to fill the gap between new observations and the predictive power of the model led to the addition of adjust­ments that produced ineffectual complexity.

On the contrary, the G20 political reaction to the recent crisis has not been based on a change of paradigm. The self-criticism was limited to the identification of spe­cific weaknesses of the previous regulation, which could be corrected by means of a more precise calibration of prudential regulation in Basel III and the addition of a new celestial sphere—macroprudential supervision.⁵ The danger coming from the laissez- faire approach does not only come from the fallacy of composition of a microapproach. Because the sum of healthy banks does not necessarily produce a healthy banking sys­tem, a macro or systemic surveillance is necessary. The problem also lies in defining healthy banks according to their own profit-seeking risk metric. Fundamentally, the alternative is between policy makers designing a resilient financial structure and, as cur­rently accepted, leaving the financial skeleton and its ex ante resilience to be dynamically molded by private interests.

Oblivious of the fact that financial laissez faire has increased the frequency and seri­ousness of crises, the new mantra of policy makers is that banking and financial crises have always existed, so that, interfering as little as possible with the privately induced financial dynamic, we must be prepared to manage crises in a nondisruptive way. Instead of further strengthening ex ante defenses, the main effort, made through the Financial Stability Board, has been directed at producing a regulatory standard for the swift res­olution of failing systemic banks while shifting its costs from public finance to private investors.

A further point of the regulatory response has been to endow supervisors with enhanced powers (Tonveronachi, 2010; Haldane, 2013). This might appear a bit far­fetched given the criticisms leveled against precrisis supervisory practices as being too light touch and market friendly. Actually, all the crises experienced after the adoption of Basel’s requirements have seen banks ex ante complying with that standard. In any case, if supervisors were cautious in their interventions, they were interpreting the spirit of a market-friendly regulation correctly. As an example, let us recall the message given by the Basel Committee of Bank Supervision (BCBS) when presenting the Basel II release (Caruana, 2004; Himino, 2004; Wellink, 2007). The aim, at least regarding large and sophisticated banks, was to align the regulatory capital to the economic capital that a bank autonomously computes following the industry’s best practices.

A well-run bank chooses among the available methods for computing and hedging risks the one that best reflects its long-term interests. However, three questions should arise when taking the regulatory point of view: whether the long-term interest of well­run, but profit-seeking, banks coincide with the objectives that regulators should follow; whether best practices also mean socially reliable practices; and whether the ideas of what constitutes the industry’s best practices coincide across national regulators and between them and banks, and how this relates to the attainment of the regulatory level playing field. To deal with these questions, a general outline of why and how banks are regulated according to the current laissez-faire approach is needed.

The why, at least as far as Basel is concerned, refers to stability The first release of Basel only addressed large international banks that were considered efficiently run, but lacking the right incentive as far as capitalization was concerned. Because, for a variety of reasons, debt is preferred to capital, banks tend to save on capital, thus exposing them­selves to the risk of insolvency when hit by unexpected losses, that is, losses larger than the statistically computed expected ones hedged by specific reserves. Therefore, a metric is needed to compute unexpected losses, and a decision must be taken on how much capital is required to cover them. When the BCBS speaks of best practices, it apparently refers to the methods for computing risks, reserving for itself the decision on the degree of their capital coverage. The latter has been set with capital per unit of assets not lower than 8 percent of the average risk weight. If, for example, the average risk weight is 50 percent, capital must cover unexpected losses for at least 4 percent of the total assets. However, the magic 8 percent does not emerge from some formal metric but apparently from the actual capitalization of a sample of international banks when, in the second half of the 1980s, the BCBS decision was made. Therefore, also regarding minimum capitalization, we have what is in essence self-regulation, because the reception of the status quo ante for the level of capitalization contradicts the regulators’ premise that also well-run banks have strong long-term incentives to be undercapitalized, as the pre-1980s trend impressively shows. The capital buffers and the additional requirements for global banks introduced by Basel III as a reaction to the recent crisis introduce a new magic number, 2.5 percent, which we may suppose is again an empirical compromise with the industry By the way, it is far from clear whether these additional requirements cover the increase in complexity, financialization and large banks’ systemic footprint with respect to the period (the mid-1980s) when the previous 8 percent coefficient was decided.

The second crucial point concerns the methodology for computing the amount of risks to be hedged with capital. Starting from Basel I.5, regulation for the largest banks adopted the industry standard based on value at risk (VaR). Even if we were to allow that this is the best quantitative method available to banks, it does not necessarily rep­resent a reliable solution for systemic stability purposes in an environment of risk com­plexity freely determined by banks.⁶ In an uncertain world, quantitative methods filled with data taken from the past just produce educated guesses, while the real threat comes from estimated safe assets turning risky (Kregel, 2011; Roncaglia, 2012; Persaud, 2015). Furthermore, their reliability crucially depends on the complexity of risks managed within each institution, especially large ones, and on the complexity of the interrela­tions characterizing the financial and economic system. Because a quantitative method is a simplified representation of reality, its reliability decreases exponentially with the increase of complexity. Permitting a large variety of private interests to mold financial systems, the laissez-faire approach to regulation is responsible for the enormous increase of the financial complexity of the last decades, hence for the reduced relevance of the risk methodologies that it employs.⁷

As to whether the notions of best practices for regulators and for banks coincide, sev­eral factors point toward a negative answer. Laissez faire means the absence of internal and international barriers, leading to a global market in which institutions and products are free to operate and circulate. Competitive regulatory conditions mean that global actors are to be submitted to homogeneous rules. The regulatory level playing field and the common methodology then require that any bank facing the same data should pro­duce homogeneous risk evaluation. Tests made after the inception of the recent crisis, asking several banks to use their internal models to compute the risk weights for the same banking and trading portfolios, have produced highly dispersed results. Because the internal model is what also guides a bank in computing its economic capital,⁸ the result of the tests shows that we can hardly speak of an industry’s common standard. In order to save the principle of the regulatory level playing field, the BCBS has reacted to the result of the tests by proposing restrictions to the typologies of internal models that banks are allowed to use. Apart from increasing procyclicality, for the majority of banks the adoption of this proposal would further distance their risk management and capital calculation made under the regulatory regime from what they would otherwise have chosen. The same line of reasoning applies to Basel’s standardized methods for computing risk weights because they come from calibrations made on samples of smaller banks. In this case, too, we are led to suppose that the dispersion around the chosen coef­ficients is significant. By also adding various prudential multipliers and politically moti­vated demultipliers, regulators are increasingly asserting themselves to be the equivalent of good bankers.⁹ The resulting complex set of incentives significantly affects, or distorts, banks’ behavior and consequently the pricing of assets.¹⁰ It should then come as no sur­prise that banks and other financial actors react, also through their freedom to innovate, to a distorted market-friendly regulation.

Beside apparently homogeneous rules not producing homogeneous results on risk weighting, other elements concur to further distort the international regulatory playing field. Most relevant are national discretions and heterogeneous accounting standards touching on crucial elements such as the components of regulatory capital, consolida­tion rules, the treatment of off-balance-sheet exposures, derivatives and provisioning. The increased relevance of Basel’s Pillar 2, with its supervisory review and evaluation process (SREP), gives national authorities further room for distorting the playing field. The stress test exercises, which are a relevant aspect of the SREP, build on the doubtful and divergent internal risk metric discussed above, stressed with ad hoc scenarios. The markets, which should help supervisors discipline banks (Pillar 3), appear so confused by a complexity built on discretion and opacity that they often base their evaluations on simpler indicators, such as the unweighted leverage ratio and the Texas ratio. The cur­rent regulation also bends the playing field in favor of large banks, which are permitted to employ internal models that save on capital with respect to the standardized methods reserved for smaller banks. In addition, the latter do not have the means and power to react to a distorted regulation and to avoid diktats by supervisors.

Both private interests and regulation have thus concurred to create a mission impossi­ble for bank management, markets and supervision. The thousands of pages of instruc­tions that supervisors pour on bankers for regulatory compliance are the mark of the ineffectual complexity of supervision, not the solution.¹¹ Because the absence of pub­lic influence on financial structure also means the absence of a general and consistent design for regulation, regulatory interventions go after specific “excesses” defined in rela­tion to what supervisors increasingly idealize as the best practices in the diverse branches of the financial system. Nonhomogeneous national or regional rulebooks and supervi­sory handbooks have thus become the official textbooks for good financial managers. However, risks are created globally, shifted and accumulated independently of the best intentions of national regulators and supervisors. What appears to be a heavily regulated system is actually a costly and distorted dysregulated one. Starting from the idea that freedom means competition and efficiency, the regulatory problem comes from its first principles, which leave financial institutions, especially global ones, free to innovate and create and take any type and amount of risks.

Ultimately, since the level international playing field is the necessary companion of global finance, the actual nonexistence of the first should lead to a profound reconsider­ation of the latter.

Financial laissez faire has also pushed up the systemic relevance of institutions that have increasingly become too big, too complex and too interrelated to be managed, supervised and resolved. In the current regulatory context, competitive conditions con­strain financial actors to homogeneous rules, which do not include in any meaningful way limits to their market power.¹² As we observe generally, the adoption of the theory of contestable markets has meant looking for the misuse and not for the existence of market power. If nonnatural monopolies are often barred, especially those of foreign ori­gin, oligopolistic markets dominated by a few large firms are the norm. This permits not only extreme cases of market manipulation, as the ones recently sanctioned, but also less glaring practices—helped by the basic cooperative nature of banking—that are difficult to prosecute. As Sylos Labini (1962) observed a long time ago, there is nothing wrong in principle with cartels; the judgment must rest on whether they serve general purposes. If, as we can easily observe, the extra returns created under the laissez-faire regime are seized within firms and the financial sector, or are utilized to finance larger and more fragile financial dimensions, they serve private (not general) interests. Even more wor­ryingly, the concentration of market power serves to manipulate political decisions in

order to sustain the laissez-faire regime from which that power derives. The distortion of democratic rules is what also differentiates a laissez-faire system from a liberal one.¹³

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