Remarks to the 12th Annual International Seminar on
Policy Challenges for the Financial Sector
By Mohamed El-Erian
June 7, 2012
Let us start with a few unambiguous realties that, nevertheless, sometimes veer quickly into controversy.
I suspect that virtually everyone would agree that, in the last few years, we have seen an unprecedented focus on regulatory reform, and rightly so. Indeed, the issue has not been the input but, rather, the output.
Since the financial crisis, lawmakers in several countries have passed on paper seemingly sweeping financial reform, and regulators have been working hard to implement the details at a breakneck pace. Examples of national, regional and multilateral initiatives include (and are certainly not limited to):
The Dodd-Frank Act in the United States that, among other things, involves the overhaul of the derivatives landscape, increases transparency and disclosure, implements the “Volcker Rule” that limits trading activities within banks and establishes measures meant to address both “too big to fail” and systemically important institutions;
The European Market Infrastructure Regulation (“EMIR”), which, similar to Dodd-Frank, addresses derivatives trading, central clearing, fund structure and reporting and disclosure requirements in Europe;
Markets in Financial Instruments Directive (“MiFID”) II, which, in updating the original directive, addresses issues of high frequency trading, transparency and position limits in Europe; and
Basel III regulations on capital requirements and other aspects to be phased in between 2013 and 2019.
In both motivation and design, these reforms
seek to address many of the sources of instability that played a role in
the global financial crisis. For example, they aim to ensure:
Stronger regulation and more robust financial institutions, including increased capital cushions, which (in level and quality) are rightly seen by the vast majority of people as critical to the safety and soundness of institutions and the system as a whole;
Plugging regulatory gaps to improve appropriate oversight over key players and products, including those that previously migrated to the shadow banking system;
Derivatives reform, including central clearing, where the goal is to reduce counterparty risk, increase transparency, improve price discovery and provide regulators with a better handle on information that speaks to the financial health of the system/key players. Also better margin requirements on non-centrally cleared derivatives;
Increased transparency over market transactions, including electronic trading platforms/increased real-time price information and transparency, which shine a better spotlight on the once bespoke, opaque, bilateral swaps markets;
Increased protection for consumers and retail investors in their interactions in financial markets; and
Addressing “too big to fail” by requiring the relevant banking firms to hold additional capital cushions and adopt “living wills” that outline how they would wind down in the event of a default.
Plenty of Initiatives and Yet…
The list of activities is indeed long, with only a subset being mentioned here. Yet the general sense is undeniable: The post-crisis regulatory effort has yet to convince enough people that the situation has materially improved and that the fundamental sources of systemic instability within the financial system have been addressed. Indeed, if anything, there is still too much discomfort and disappointment.
This sentiment is quite common and, I
suspect, is particularly frustrating for those who have spent so much
time, hard work and dedication to craft a better regulatory and
supervisory framework. And with periodic examples of yet more stumbles
among highly visible financial institutions (the latest being JPMorgan
Chase’s highly publicized loss in one part of its business), the
complaints are sure to keep coming – loudly and from across the
A number of reasons can be cited for this
unfortunate situation. Let us first start with those that come with the
territory and are therefore largely unavoidable.
We should never forget that, especially in
this complicated and evolving area, the devil is inevitably in the
details: Although many of the reforms are positive in theory, their
practical impact depends on how they are implemented, and this requires a
tremendous amount of work, coordination and, in some cases,
Dodd-Frank and EMIR delegate much of the
implementation to the regulatory agencies, and that work is ongoing. So,
to use a baseball analogy, we are still in the early/middle innings of
the rulemaking process and its global harmonization.
Any regulator will tell you that translating
laws into accountable actions that can be well-monitored is far from
easy. Regulators have to balance getting the rules right, being
thoughtful and deliberate, while also completing them in a timely enough
manner. Moreover, all this must be conveyed clearly, including a high
degree of content and date certainty – not just for general
communication reasons but also to provide financial institutions and
markets the clarity to understand the rules of the road and respond
accordingly. In addition, regulators need to keep an eye on the
potential unintended consequences of their actions and statements.
Given the pace lawmakers and regulators are
trying to implement these reforms, together with the enormity of the
regulatory overhaul and the economic/sociopolitical context,
disappointments are almost unavoidable. Recall that interagency
coordination and policy harmonization is notoriously hard within
national borders; and it is even more complicated across borders. And
because we start with a situation where regulators are already
struggling with overlapping and sometimes conflicting rules and
jurisdictions, they now find it even more difficult to harmonize and
evolve new rules in the context of complex joint-rulemaking initiatives.
This issue has played out vividly in several
areas of rulemaking. Agencies in Europe and the U.S. have proposed
different criteria, deadlines and implementation schedules for almost
identical concepts (e.g., block trades, real-time reporting standards
and margin for uncleared swaps). Among the various follow-ups, a number
of lawsuits have emerged, thus adding to the complexity for those hoping
to understand and react to the evolving regulatory environment.
When time is of essence, there is also a
natural temptation to fast-forward the detailed cost-benefit analyses
and also treat different institutions in overly similar ways. Here, more
of the disappointments could – indeed, should – have been handled
Comprehensive and transparent cost-benefit
analyses underpin proper regulatory reform. They are crucial to ensure
the right balance between social costs and benefits. And it is not just a
matter of getting the analytics right. This is also key for effective
public dissemination, including convincing often competing interests
that the regulatory efforts are justifiable and fully defensible.
Moreover, regulation needs to be commensurate and appropriate to the
specific industry and activity being addressed.
Some examples suggest that these elements
have not been handled as well as they could have. Delays in one area
specific to one group of institutions can give rise to haste in the
broader implementation to a much broader set of institutions that do not
share the key risk attributes of the first.
Then there is the political dynamic and
narrative. As they work on finalizing regulations, regulators must deal
with pressure from elected representatives, some of whom can be seen as
driven by short-term, election-motivated interests that may conflict
with the original intent of statutes.
Additionally, regulators must secure the funding needed to implement the range of new mandates. This process has been handled poorly, which is partly a reflection of the unusual polarization that now dominates too many political capitals, but also due to bad communication and inadequate consultations.
The political angle plays straight into another ubiquitous practice, particularly in the U.S. – that of excessive lobbying on the part of private interests. While a robust dialogue between regulators and industry participants that seeks good two-way information flow is important, some of today’s lobbying practices go well beyond the legitimate objective of bringing better data and analysis to the table.
In several cases, excessive lobbying has created disruptive tangents and made the desirable overhaul of regulation hostage to very specific micro issues that are of relevance to only a small group of institutions (or even just one institution). It has also fed into concerns that money can undermine proper analysis and better outcomes.
The regional and multilateral perspective is
even more complicated. While the G-20 has committed to working together
on financial reform efforts (including via the 2009 Commitment Letter),
the reality has been disappointing. And the resulting patchwork of
reforms increases complexity.
Without proper national and cross-border coordination, regulatory confusion and arbitrage are likely outcomes. In addition, there are already too many indications that some countries risk slipping into regulatory protectionism.
Perhaps the worst outcome of the last few years is the inadvertent signaling by some officials that regulation offers a panacea of some sort – so much so that some expect regulatory initiatives to meet in a simultaneous manner the multiple objectives of soundness, efficiency, fairness and growth.
There are also limits to the role regulation can play in ensuring proper behavior. For example, it cannot fully compensate for self-inflicted slippages on the part of all public and private institutions. It can influence behavior, yet it cannot guarantee the absence of fraud and other financial crimes. Furthermore, it can often be superseded by new developments on the ground.
Regulation can never – indeed, should never – replace the responsibilities that private market participants have in pursuing good risk management and being responsible stewards of their clients’ or firms’ capital. Yet, judging from certain official statements, there is undue haste and ambition in declaring what can be achieved, thus undermining the credibility and sustainability of responsible regulation and supervision.
Regardless of how you grade the efforts to date of regulators, and no matter how good their intentions have been, it is hard not to feel the degree of disappointment among the public at large. And the result is yet another factor that inhibits the recovery in growth and jobs, the proper functioning of markets and, because of that, the mobilization and allocation of funds to productive activities – thereby exacerbating the synchronized slowdown that is now taking hold of the global economy, the growing wealth and income inequalities, and the pockets of severe financial instability.
We have not undertaken the analysis of singling out the precise impact of the incomplete and often faltering regulatory effort. And we suspect that it would be analytically very hard to do so given the unusually fluid nature of the global economy. Nevertheless, we get the sense that it may well be consequential.
At PIMCO, our periodic assessment of the regulatory landscape now always includes recognition of how much
is still in flux and, essentially, both unknowable and unquantifiable at this stage. The result is yet another uncertainty and complexity risk premium that is subject to wide bands due to the complexity involved. This is reflected in expectations of risk-adjusted returns on various activities, including in pricing out certain activities and scaling others down.
What happens at PIMCO seems to be replicated
in many other areas. Witness the data on the unusually large cash
holdings on balance sheets, lack of long-term investment outlays, and
the steepness of certain inter-temporal and credit curves.
Like others, PIMCO is also operating in the context of markets that have seen both a reduction in overall liquidity and a diversion of part of what remains to public sector activities. Think of this as adding a greater liquidity risk premium to the analytics of allocating funds.
Then there are the operational issues. Like most other firms that are reacting to a wave of new regulation, PIMCO has increased its legal and compliance staff around the world, and it has enhanced even more its efforts to monitor and react to regulatory changes in a large number of national jurisdictions.
The regulatory flux is part of a much broader global phenomenon – and one that is leading to quite a few unthinkables that call for a better understanding of the rapidly evolving set of risks and opportunities – for individuals, companies, countries and the global economy as a whole; and at the sector, national and international levels.
After an age of excessive debt and credit
entitlement, advanced economies are in the midst of a complex multiyear
phase of delevering. With proper growth eluding most countries – and
therefore limiting the option of “safe delevering” – these economies
will experience an unusual mix of financial repression, credit risk and
defaults. In some cases – as we are seeing in Europe today – this will
result in severe instability and questioning about the very construct of
the economic and financial system.
In addition to this delevering, the global economy is challenged to accommodate the breakout phase in a number of systemically important emerging economies. And some of these countries face the internal challenges of managing their middle income transition.
Then there is the issue of multilateral economic governance. The reality of a global realignment, and the risk of a synchronized global slowdown and related financial instability, call for much stronger global policy coordination – especially given the potential (and in some cases, the reality) of disorderly delevering with both national and cross-border consequences. Yet the U.S. has lost part of its traditional leadership and anchoring role. The G-7 and multilateral institutions lack sufficient legitimacy and credibility. And the G-20 is still establishing its operational effectiveness.
All of this serves to complicate the linkage between regulatory reform and global well-being – and it does so
in two ways.
First, it limits the probability of a
virtuous cycle, where global expansion and financial tranquility
facilitate regulatory reform, and where regulatory reform boosts
confidence that productively engages idle capital and enhances
investment, growth and financial stability.
Second, it increases the probability of a vicious cycle. Here, regulatory uncertainty further inhibits investments and other productive economic activities; this, in turn, makes regulatory success even more difficult as regulators find the ground slipping from underneath them in an unpredictable and volatile manner. And the range of feedback loops – especially between weak financial systems and weak macro economy/sovereign creditworthiness – continues to risk even worse outcomes.
Having already missed several important economic and political windows, regulators in advanced countries find themselves in an even more challenging situation. If they are not highly attentive, they risk finding their well-intentioned efforts to enhance safety and soundness inadvertently accelerating the synchronized downturn of the global economy. It also does not help that they are operating in an unconventional policy environment that complicates the fulfillment of many objectives simultaneously.
The response to this is not – and I stress
not – to slow regulatory reform. Instead, the proper response is to
proceed in a more coherent and coordinated fashion and, equally
important, it is to limit the likelihood that tactical mindsets will
again be allowed to overly dominate strategic ones.3
Gatherings like this one provide an important
opportunity to assess where we stand, how the overall environment is
evolving and which midcourse tweaks are both feasible and desirable. In
doing so, you will address the delicate balance between benefits, costs
and risks that accompany major policy initiatives. And in analyzing in
detail the many intricacies of actual and prospective regulatory
changes, please also keep a close eye on the interactions with the
bigger macro issues that, once again, are dominating the global
economic, financial, political and social outlook.
2 See “Policy Confusion and Inflection Points,” PIMCO, May 2012
3 See “The Strategic Vacuum,” Foreign Policy, April 2012