Calls for new and better regulation have resulted in the introduction of a number of financial regulations during recent years. Sean Tuffy of Brown Brothers Harriman wonders whether the new regulations really provide investors and markets with a safety net to prevent another financial crisis
The flight attendant’s safety speech has become so familiar and iconic that most air passengers know it by rote, and very few people ever take the time to listen to it – let alone consider if the safety measures described actually provide safety, as opposed to the illusion of safety. For example, the lifejackets that are conveniently placed underneath the seats are intended to be used in the event of an emergency landing on water – but in the history of commercial aviation, a wide-body plane has never successfully executed a deep water landing. Whereas the most mundane and most ignored part of the safety speech, which is to keep the seatbelt buckled at all times, offers proven security in the event of a sudden burst of turbulence or an emergency landing.
Following the cataclysm of 2008, there were calls for new and better financial regulation. Almost three years later, a number of new regulations have indeed been introduced. The intent of these regulations is to provide investors and markets with a safety net to prevent another financial crisis. But before the industry starts reciting these new regulations by rote, it makes sense to review some of these new safety mechanisms, to determine if they are merely symbolic lifejackets, or infinitely more useful seatbelts.
Regulating the remuneration of investment bankers, asset managers, hedge funds and private equity firms is a cornerstone of the regulatory push in Europe. Regulators in both Brussels and London have pushed through new remuneration rules which are designed to reduce risky behaviour. There are three key parts of the new rules:
• At least half of variable compensation must be paid in shares or an equivalent instrument;
• A large portion of the variable compensation (40-60 percent) must be deferred for three to five years;
• There must be claw-back measures to reduce compensation, if there is under-performance in the future, built into compensation schemes.
The regulations were drafted in the wake of the collapse of Lehman Brothers. The logic behind the new regulations is to reduce short-term thinking and align compensation models with risk-management principles and overall firm success. These are all well-meaning goals – but will the policies actually achieve them?
The lesson from history is that the answer is ‘no.’ If we look at what actually happened at Lehman Brothers, these policies would have changed nothing. A majority of Lehman Brothers’ staff’s variable compensation was in the form of restricted stock. This stock was priced at the market price (as of the date of issue) and took several years to vest. By any objective measure, this remuneration policy seems to be a model for the new regulations. Yet, it did nothing to forestall the risk-taking and ultimate collapse of Lehman Brothers. In fact, restricted stock is a mainstay of US financial firms’ compensation models – but the financial crisis happened in spite of it.
The idea of regulating remuneration policies to encourage more prudent risk-taking and long-term thinking is an attractive concept. However, it is likely that such policies will have little actual impact.
Dodd-Frank act: skin in the game
A key element of the US Dodd-Frank Wall Street Reform and Consumer Protection Act is the so-called ‘skin in the game’ provision. In fact, the co-author of the bill, Representative Barney Frank, has called the provision the “single-most important part of this bill.”
The skin in the game provision requires mortgage securitisers to retain five percent of the risk they create when packaging mortgages for sale. This provision was drawn up in the wake of the mortgage-backed security issues that are credited with triggering the great recession. The logic behind the provision is that if institutions are forced to retain some of the risk with mortgages, they will take a more prudent approach to risk management. This, in turn, will reduce the chances of repeating the issues that caused the great recession.
The ideas of encouraging better risk management and prudent lending are laudable goals. However, this provision, while correctly diagnosing one of the causes of the financial crisis, does not resolve the root issue – namely, that the vast majority of industry participants did not view securitised mortgages as risky.
In fact, according to the credit rating agencies, a majority of these securities had AAA ratings. Up until the moment that the crisis truly took hold they were prime investment vehicles. When the true depth of the problem was revealed, most banks and investment funds were pricing mortgage-backed securities at par. Therefore, the skin in the game provision would not have mitigated any risky behaviour because, until it was too late, the investment in mortgage-backed securities was not viewed as risky.
Much like the remuneration regulations in the EU, the logic behind the skin in the game provision appears sound. Unfortunately, the provision does not address the fundamental issue, which was the basic miscomprehension of the riskiness of mortgage-backed securities. The truth is that many banks in the US that issued bad mortgages had large amounts of skin in the game, which may be the reason for the record numbers of bank failures in 2008-9.
Regulation by subtraction
We tend to think of regulation in the context of new rules. However, regulatory change can also come in the form of the removal of regulation. A good example of this is the Dodd-Frank Act’s repeal of Regulation Q, which came into effect on July 21, 2011. Regulation Q was a 1930s-era banking regulation that restricted the interest rate that banks could pay on deposits. There were two main justifications for Regulation Q. First, there was a desire to boost banks’ profits. Second, there was a belief that competition to pay high deposit rates would encourage banks to take too many risks.
However, by artificially holding interest rates below their natural levels, Regulation Q has had some major unintended consequences. First was the development of the Euromarket in London, where lenders and borrowers were free to set rates between themselves. Second was that small investors and corporations moved their savings out of banks and thrifts and into money market funds, which did not face a limit on the rates they could pay.
The intended benefits of repealing Regulation Q are twofold: to create new jobs and help grow small businesses, and to improve the ability of community banks to compete for deposits against larger institutions. A secondary consequence of the repeal is the removal of an artificial distortion in the market. This, in theory, will increase competition between the so-called real banking sector and the shadow banking sector. This competition should prove beneficial to the industry and, in the long run, reduce the systemic importance of money-market funds and the commercial paper market.
Given the history of Regulation Q, it is quite likely that, as happens with all regulation, there will be unintended consequences. There is also an argument that the rise of the shadow banking system was more demand-driven than a result of the restriction of Regulation Q. Ultimately, the repeal may have very little practical impact. However, it is an example of regulatory change that reconsiders regulation rather than adding multiple layers of new regulation.
Drafting successful regulation
Drafting financial regulation can be a thankless task. No matter what decision is taken, it is likely to displease a vocal aggrieved party. To further complicate matters, major changes in financial regulations tend to follow traumatic market events, when emotions are running high. This often leads to the drafting of measures which, though they seem to appeal to the electorate on the surface, do not offer any additional level of safety.
It is said that capital is like water and tends to flow around obstacles. With this view, perhaps the key to drafting successful regulation may be to take measures which are designed less like dams, and more like canals.
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