The Cycle of Regulation versus Innovation

There is an ongoing dilemma between the imposition of regulation and the efficiency, or completeness and profitability, of any market. Van Horne (1985) mentioned that the purpose of financial markets is to channel the savings of the society to the most profitable investment opportunities on a risk-adjusted return basis. There is a dynamic connection between market innovation and regulation. Financial innovation often occurs in response to regulation, especially when regulation makes little economic sense (Meyer, 1998). Economic efficiencies that are potentially associated with financial innovation can be negated by inefficient banking regulation. As regulation is perceived to hinder this process, new variants of financial products would come to the fore. Conversely, advances in the market spur the evolution of regulation. Investment opportunities may originate in the private sector, where the rate of return on the investment is paramount, as opposed to the public sector, where social returns are promoted. Therefore regulation must somehow produce a fine balance between these two positions.

The usefulness of the capital adequacy accord lies in its ability to be used as a benchmark for financial scrutiny by both regulators and counterparties alike. The various shortcomings highlighted previously, along with the ever-increasing levels of financial innovations, undermine the effectiveness of the capital adequacy requirements. With the proliferation of capital arbitrage27 techniques, securitization included, banks can effectively achieve risk-based capital ratios, which are below the Accord's nominal 8 per cent. Capital arbitrage is fundamentally driven by large divergences between economic risks and that of the risk-weighted measure set by the BIS.28 This, in addition to its efficiencies, can also give rise to distorted risk-management techniques, and from a safety and soundness perspective, risk-management distortions could be as, or even more, problematic than capital arbitrage.

By contrast, efficient banking regulation not only provides a backdrop for financial advances, but also permits governments to achieve to some extent social objectives which otherwise may have been impossible or incurred at a higher cost. With this current Accord, the phenomenon of capital arbitrage poses some significant policy trade-offs, for the only means available to regulators in limiting such activity is through the imposition of broad restrictions on the use of financial engineering technologies. According to Jones (1999), this would, however, be counterproductive and possibly untenable since capital arbitrage often functions as a safety valve for mitigating the adverse effects of nominal capital requirements which, for some activities, are unreasonably high.

A lack of understanding of the regulatory nature of derivatives could cause an increase in the risk that inappropriate regulations, or ill-conceived regulatory actions, could exacerbate or heighten financial market volatility. Essentially, capital arbitrage permits banks to compete in some activities which they would have been forced to abandon due to insufficient returns on regulatory capital needed. Moreover, securitization and other risk-unbundling techniques to some extent appear to provide significant economic benefits apart from capital arbitrage.

The debate in many instances focuses on whether inefficient or burdensome capital adequacy requirements can reduce the risks in banking. According to Blum (1999, p. 756), 'under binding capital requirements an additional unit of equity tomorrow is more valuable to a bank. If raising equity is excessively costly, the only possibility to increase equity tomorrow is to increase risk today'. Importantly, Gehrig (1995) highlighted that capital requirements greatly influence the nature of strategic competition among banks. Essentially, it must be noted that in a dynamic setting, with incentives for asset substitution, capital adequacy may actually lead to increases in bank risks. Furthermore, if the regulators are concerned with reducing the insolvency risk of banks, then one of the effects of such regulation is reduced bank profits. Theoretically, with lower profits, a bank has a smaller incentive to avoid default, along with the 'leverage effect of capital rules' which raises the value of equity to the bank. For with every dollar of equity, more than one dollar can be invested in a profitable, but risky, asset.

The 1988 Basle Accord is extremely simplistic in terms of credit risk, with banks having to contend with a rather arbitrary capital requirement of 8 per cent, although many of the internal capital allocation procedures have evolved as credit products have evolved. Regulatory requirements for capital have been oversimplified historically and tend to penalize those institutions that invest in sophisticated internal risk-management systems. Regulatory concerns about capital adequacy therefore can best be addressed by allowing qualifying institutions to use their own risk models for determining capital adequacy for credit and market risks, subject to regulatory oversight. This policy can promote innovation, as well as financial market soundness and a more efficient allocation of capital. Currently, regulatory capital rules do not fully capture the economic substance of the risk exposures arising from structured securitiza-tions.

The use of complex derivatives and complex structures has led to difficulties in the measurement of possible risk elements. The major difficulty occurs where regulatory capital requirements are not equipped to capture the complexities of some risk positions being undertaken by banks. However, risk cannot be measured in precise terms, for there are always potential estimation errors, though at some point the measurements will become sufficiently robust to warrant widespread changes in prudential regulations.

Clearly, the growth in CLO transactions, and indeed other forms of arbitrage, has been spurred by the inadequacies in the international standard. This has occurred due to the development of sophisticated models by some banks that quantify risks, including credit risk, which differ substantially from the 8 per cent regulatory standard. As the more sophisticated banks have done through rapid evolution of their system, regulators should follow suit by moving from a ratio-based standard - which says little about insolvency - to a model-based one, especially for the more complex institutions. For such institutions, this standard is inefficient in the objective of limiting bank failure to acceptable levels, since high capital ratios do not necessarily equate to low solvency probabilities. More damaging is the risk of a few institutions failing to keep pace with risk-management practices, which places all banks at risk. The risk is not simply confined to counterparty failures, but the systematic underpricing of credit risk, for example, is damaging to the financial system. Furthermore, it is possible in the long run that the regulated entity could shrink in size when compared to an unregulated one. Therefore, what are the alternatives available to ensure the protection of the banking system and investors alike?

Financial End Game

Financial End Game

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