Some Steps in the Right Direction-A Critical Assessment of the de Larosiere Report

7/29/2019 Some Steps in the Right Direction-A Critical Assessment of the de Larosiere Report

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SOME STEPS IN THE RIGHT DIRECTION: A CRITICAL ASSESSMENT OF THE DELAROSIERE REPORT

Viral Acharya4 March 2009

The de Larosiere report is an important contribution to the future global financial architecture,especially its proposals for reform of EU regulatory supervision and global coordination.There is a surprisingly broad consensus on what needs to be done to fix the global financialsystem emerging. One hopes that the G20 summit will be a platform to launch keyinternational reforms.

As the G20 April summit, which will discuss a reform of the global financial system,approaches, proposals and reports to guide such discussion are proliferating. When RichardBaldwinasked me to write an assessment of thede Larosiere report that came out last week,my first thought was that my colleague, Thomas Philippon, had just published a VoxEUsummary of some such reports (including the NYU-Stern bookRestoring Financial Stability:

How To Repair a Failed System, the G30 report chaired by Paul Volcker, theGeneva report,proposals of Luigi Zingales, among others). What could I add more? Regardless, I sat toread the de Larosiere report and realised soon that a number of different economists andpolicymakers were reaching similar broad conclusions, even if the specific shades of eachwere nuanced. The near unanimity of opinion on what ought to be the future financialstructure, even as there is perfect lack of unanimity on how to dissolve the ongoing crisis,struck me as peculiar. There must be one way to do things right and a million ways to botchthem up! Nevertheless, the unanimity on the world order for future at least on the financialfront seemed like the Cape of Good Hope. It may be hard to sort out the immediate mess,but as and when its hangover leaves us, we might have done enough groundwork to paveway for a robust, yet well-functioning financial system.

The ReportThe de Larosiere report (Report going forward) covers a fair bit of ground. It is by designfocused on the EU, but it does cover global aspects of the new reforms it proposes. Itprovides its take on the financial crisis but spends a fair bit of time on financial stabilityoversight and supervisory repair. This latter aspect of the report is its strongest part forseveral reasons. First, it is not as fully fleshed out in other reports; second, it talks aboutearly warning systems, which need a certain amount of revamp, and, finally, it touches uponthe difficult issue of how to organise supervision of different financial functions even as weset in place the so-called systemic risk regulator that will likely cut across all the functions.Instead of going through the Report point-by-point and discussing pros and cons of each, Iwill focus on the issues I found most germane. In many cases, my assessment is to anextent based (biased!) on the collective thoughts of NYU-Stern faculty who contributed to ourbook. With that caveat and an offer that you contact me if you want any bold claims below tobe substantiated with facts, let me move on

Causes and regulatory repair

Overall, the Report focuses on the usual culprits: abundant liquidity (especially loosemonetary policy in the US and the accumulation of large global imbalances elsewhere),failure of internal and external governance of financial institutions (risk management role andshareholder oversight, respectively), rating agencies modelling failures, ineffectiveness and perhaps malfunctioning of current capital requirements, and lack of any significant roleplayed in global coordination by international agencies such as the IMF, Financial StabilityForum (FSF), G20, and others.

Most of the discussion here makes sense. Some things, however, stand out.
http://www.voxeu.org/index.php?q=node/973http://www.voxeu.org/index.php?q=node/973http://www.voxeu.org/index.php?q=node/45http://www.voxeu.org/index.php?q=node/45http://www.voxeu.org/index.php?q=node/45http://www.voxeu.org/index.php?q=node/45http://ec.europa.eu/ireland/press_office/news_of_the_day/cross-border-financial-supervision-report_en.htmhttp://ec.europa.eu/ireland/press_office/news_of_the_day/cross-border-financial-supervision-report_en.htmhttp://ec.europa.eu/ireland/press_office/news_of_the_day/cross-border-financial-supervision-report_en.htmhttp://www.voxeu.org/index.php?q=node/946http://www.voxeu.org/index.php?q=node/946http://www.voxeu.org/index.php?q=node/3076http://www.voxeu.org/index.php?q=node/3076http://whitepapers.stern.nyu.edu/home.htmlhttp://whitepapers.stern.nyu.edu/home.htmlhttp://www.group30.org/pubs/reformreport.pdfhttp://www.group30.org/pubs/reformreport.pdfhttp://voxeu.org/index.php?q=node/2796http://voxeu.org/index.php?q=node/2796http://voxeu.org/index.php?q=node/2796http://voxeu.org/index.php?q=node/161http://voxeu.org/index.php?q=node/161http://voxeu.org/index.php?q=node/161http://voxeu.org/index.php?q=node/161http://voxeu.org/index.php?q=node/2796http://www.group30.org/pubs/reformreport.pdfhttp://whitepapers.stern.nyu.edu/home.htmlhttp://www.voxeu.org/index.php?q=node/3076http://www.voxeu.org/index.php?q=node/946http://ec.europa.eu/ireland/press_office/news_of_the_day/cross-border-financial-supervision-report_en.htmhttp://www.voxeu.org/index.php?q=node/45http://www.voxeu.org/index.php?q=node/45http://www.voxeu.org/index.php?q=node/973


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The Report discusses the originate and distribute model as having played a critical,detrimental role in the crisis and recommends that issuers of securitised products retain ameaningful amount of the underlying risk (non-hedged) on their books for the life of theinstrument. In my opinion, the originate and distribute models role in this crisis has beenoverplayed and distracted attention away from the primary problem that banks securitised

without actually transferring sufficient risk.Let me elaborate, as we have explained in the NYU-Stern book.

A large fraction of the mortgage originators in the US are now dead why? Because they didhave skin in the game, as economists would like them to have. Those who were supposed totake these risks and distribute them to rest of the financial sector government-sponsoredentities (GSEs) in the US and commercial and investment banks the world over are,however, also close to being dead or on oxygen! This is because those who weresupposed to and believed to be spreading risks around, instead took a large economicbet. They held the safest securitisation tranches, but did so for 53% (GSEs and banks puttogether) of all AAA mortgage-backed securities. The risk was low but the leverage sky-high.It was this phenomenon that converted the economic shock into a full-blown financial crisis.

To summarise, the real problem in the chain of linkages from origination of mortgages to theirultimate risk bearers occurred at the point of large banks and the GSEs. Once one focuseson what went wrong at this link and why, it is clear that some other aspects the Reportfocuses on the perverse incentives of bankers given governance failures, the presence ofunder-priced (and in many cases, simply un-priced) government guarantees, the gaming ofBasel capital requirements, and the opacity of securitisation structures and credit derivatives appear to be the primary problems to go after.A related point is marking-to-market, in whose absence funding would dry up for financialinstitutions much sooner than it has in its presence. Again, the real issue was incentives andnot marking-to-market per se. Short-term incentives due to churning of traders across firmsinduced, and poor or silenced risk management enabled, those in charge of marking booksto inflate prices and ride/create the asset bubble.

The Report does a pretty good job of proposing reasonable solutions to fix some of the realproblems multi-year setting of bonus standards, stronger roles for chief risk officers incompany governance, pre-funding of deposit insurance funds (a missing feature in manycountries in the EU), standardisation of derivative contracts with centralised clearing, andgreater transparency requirement for the parallel/shadow banking sectors. These strike achord with many of the other reports around.Thus, on balance, the Report scores well, but it is not exactly regulation-light! It perhaps errson the side of recommending too many interventions. It is quite likely that fixing a few rootcauses might be more desirable than going after every single symptom. The Report simplyneeds to prioritise its comprehensive list of policy reforms to achieve this.One notable omission is any direct discussion of the too-big-to-fail problem and howregulators should quantify and/or penalise the systemic costs imposed by the growth and

risk-taking at large, complex financial institutions. Another notable omission is a moredetailed discussion of the problem that overall capitalisation of EU banks was poorer thanthat of the US banks (though the US banks took bigger risks), primarily due to lowerinsistence on prudent Tier 1 ratios in the EU. Indeed, marking-to-market also appears tohave been more done conservatively by US banks (at least during the crisis), implying thatEU banks may have more skeletons in their chest to take out in case the economic malaisepersists. Some of these issues deserve greater investigation and discussion in a futureversion of the Report.

Supervisory and global repair

This aspect of the Report is truly first rate conceptually clear and with sufficientimplementation details (see Annex of the Brief Summary of the Report).The overall approach is three-tiered:


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1. A systemic risk regulator at the top the European Systemic Risk Council, whichthe Report recommends be housed at the European Central Bank.

2. Functional regulators in the middle European banking authority, Europeaninsurance authority, and European securities authority, for the respective functions.

3. National versions of the three functional regulators at the bottom.

The functional regulators in the middle and the bottom would deal with each other; nationalregulators would coordinate their day-to-day supervisions; European functional regulatorswould coordinate overall supervision, macro-prudential supervision, and crisis-resolutionactivities; and finally, the European Systemic Risk Council would decide on the overallmacro-prudential policy, employing risk warnings as inputs to EU supervisors (the middle)and giving them adequate direction based on comparisons across member countries.Overall, this structure is attractive. It makes it clear that the key is to coordinate, not tocentralise all activities in one institution. It also makes a definitive bid to set up anoverarching regulator that can take a systemic perspective and cut across the variousfunctional regulators and institutions. It recommends setting up global colleges of

supervisors for cross-border institutions. Coincidentally, the scheme is rather similar to theone proposed in the NYU-Stern book, which recommends that every nation adopt a systemicrisk regulator for its large, complex financial institutions and this regulator work with all thefunctional regulators and supervisors for banking, insurance, securities, and exchanges (whowill do this last task is somewhat unclear in the plan of the de LarosiereReport).

The Report presents a timeframe of 2009-2012 to achieve this overall apparatus.

The systemic risk regulator, the European Systemic Risk Council, is also supposed to playan important global role. It is meant to harmonise several national regulations, importantlythe Deposit Guarantee Schemes and their pre-funding, application of capital requirements,and quality of supervision standards. Any national exceptions are to be carefully assessedand approved. The Report sees the BIS, the FSF, and the IMF as all being relevant bodies to

be informed about macro-prudential risks that relate to a global dysfunction of the monetaryand financial systems.The proposed model of a central bank-based systemic risk regulator aligning internationalregulation at a global forum seems the right one. But do we need the FSF, BIS, and IMF allthere? This concerns me somewhat.Perhaps the goal is to again coordinate rather than centralise, and that is what the Reportmight have in mind. For instance, it suggests that the FSF will be the primary coordinatingbody across nations, with BIS helping set international standards and the IMF helping outwith early warning systems such as its Financial Sector Assessment Programme and alsodeveloping a global early warning system for financial stability based on global risk map andcredit register. The Report also suggests an effective tax on non-abiding jurisdictions byrequiring activities with their financial centres to be subject to higher capital requirements. Onnet, it favours a stronger role for the EU in the IMF and other multilateral fora.Overall, there is little to complain about this part of the Report. It is well thought out andclearly laid out. One quibble, if I may, is the following. Though the Report does flag the issueof burden-sharing of the resolution costs for large bank failures, it would be good to get somemore details on this rather important issue. My instinct is that we have yet to witness the bigproblems on this front. If some large banks or countries were to default, some clarity inthinking about burden-sharing among member EU states would help the authorities avoidlosing valuable time in mid-crisis negotiations.

Conclusion

To summarise, the de Larosiere report represents an important contribution to providing a

blueprint for the future global financial architecture. It takes several important steps forward,especially on its proposals for reform of the supervisory role in the EU regulation and to an


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extent also in the global coordination of reforms.I wish to reiterate what I said at the start. There is an amazing consensus that is emerging onmany things we need going forward to fix the global financial system. One hopes that theG20 summit wont end up being the battlefield for countries and regions to win moral groundson how to achieve this but instead a platform for genuine international alignment of key

prudential reforms.Well, let us wait and watch!

Documents

Some Steps in the Right Direction-A Critical Assessment of the de Larosiere Report