Regulatory Fatigue in Financial Services

Executives from leading financial institutions and think tanks joined policy makers, academics, and management consultants at the Brussels campus of Vlerick Business School for three spirited panel discussions on financial-services regulations in the European Union. Vlerick Business School recently opened its Center for Financial Services as an institution for high-quality research, teaching, and thought leadership. The Center hosted this event as European leaders were debating the new supervisory role of the European Central Bank (ECB). Held under Chatham House Rule, this paper does not offer specific attribution on points raised, but draws selectively on the many valuable contributions. The appendix on page 9 has the list of participants.

The gist of the debate is that scale and regulatory costs have increased dramatically in the European Union, and that while governments want to tighten control over the financial sector in general, financial institutions as a whole and banks in particular warn that more regulation threatens to become counterproductive, eroding their ability to lend and thus undermining the prospects of new investment and growth.

Everyone seems to agree that strict regula- tions are both required and desirable, but they must be appropriate, adaptive, sufficient, and transparent. There is widespread doubt that current regulations embrace these qualities. Indeed, regulations really aren’t all that appro- priate, given the excess focus on retail banking and less on other financial industry segments, such as shadow banking. They may be adaptive, but in the wrong way, as pre-crisis regulations slowly enabled global integration, but post-crisis national tightening has led to fragmented, inward-looking and contradictory policy. Sufficiency is difficult to define, but the current approach may lead to overkill. Lastly, transparency—less since the involvement of various regulators in a single financial institution— leads to contradictory effects. Overall, the equilibrium between free market and regulation remains elusive—and the continuing crisis may affect it even more.

Where Did We Go Wrong?

Participants in the first panel, “How has Policymaking Ventured in the Financial Industry?,” agreed that while regulation is generally perceived as a cost to institutions, it also offers opportunities. Governments and regulators need to be agile, and financial institutions must be ready to exploit new business possibilities. One panelist noted that if traditional bank-led finance is declining, corporate bonds, crowd financing, and private equity all show promise. But these are supervised by different authorities, and perhaps the problem is not that there’s too much regulation, but too many regulators interfering, which leads to implementation of fragmented and inconsistent policies.

According to the panel, the financial crisis provoked a major regulatory review based on the following:

  • The system must have been faulty because it failed to prevent the crisis
  • A banking system considered “too big to fail” creates massive moral hazard
  • Profits remained private, while losses had to be bailed out by the taxpayer as insurer of last resort
  • The public lost faith in the markets and perhaps in the regulators

Now that the pendulum is swinging back, are we on the right track to make policy and regulation work? The strategic challenge is in combining two objectives: reducing the probability of failure and the cost of failure. It is fairly easy to define a banking system where probability of failure is extremely low, but the rare failure would come at very high cost to society. What we really need is a holistic strategy for reaching both objectives, but this in turn leads to other issues.

Our human nature is to overreact because we rely on our most recent experience. So regulators set objectives to fix the current situation, and bankers react with some form of regulatory arbitrage. In short, complexity smothers accuracy despite being precise.

A potentially viable solution is to focus on minimizing the cost of failures. This would mean taking a holistic view of all regulations and their cost-benefit ratios, and adding a fourth pillar to allow for international bank-failure resolutions. This new ideal level of regulatory intensity should match the lower cost to society of bank failures.

The panel noted the extent of regulatory ubiquity. A global insurer, for example, must report to more than 400 different regulatory bodies, and an international banking group must adapt to 16 new regulations a day—obviously current policy is neither focused on the links between business and markets nor ease of implementation. Also, banks occasionally face conflicts of interest with clients, while asset managers, generally more aligned, face a multitude of regulations. Is this really necessary?

Some policies hamper growth. Since the national governments took control during the crisis, for example, loans to China have fallen off. A fear of paramount losses could prove an overreaction in the long run.

Not surprisingly, the relationship between regulators and industry participants is best described as antagonistic, and worst as spoiling for a fight. Indeed, one panelist said regulators see the relationship as “the bar brawl they always wanted to have, and finally can have in full, with an already weakened opponent.”

Clearly, all core banking functions are affected by the current wave of regulations, and with wide-reaching, sometimes contradictory implications.

The track record of self-regulation and externally driven regulation is mixed. In transaction banking, regulations are largely designed to drive down costs, foster innovation, improve customer protections, and promote healthy competition. For example, the externally imposed deadline to ensure an efficient migration to new payment formats in Europe illustrates that self-regulation does not always work. In contrast, self-regulation in foreign exchange settlement did work: Combined with appropriate policies, it ensured that cross-border capital flow continued during the crisis.

Good regulation, according to the panel, is characterized by two elements: effectiveness and legitimacy. Today, there is too much fragmentation in regulations, the EU’s actions are not sufficiently integrated, and many of the local national regulations appear ineffective. Understandably, policy makers have not reacted well to the crisis and are running out of ideas to contain it and stimulate growth—as the current interest rate policy clearly shows. For example, long-term risk in the life-insurance industry is on the rise, where many believe cheap money will be very expensive in the long run. Who will explain this to consumers?

How Do We Move Forward?

Contrary to earlier remarks, the second panel, “Which Avenues can be Explored to Improve Policy Setting,” offered the opinion that perhaps regulators should not be adaptive at all. All crises have similar patterns: leveraged growth, collective madness, and “bubbles,” often supported—or at least not hindered—by politicians. Though crisis symptoms can be detected very early, they’re usually ignored, so it makes sense that applying existing policy in a stricter way over the long term would be helpful. If the Glass-Steagall Act hadn’t been repealed in 1998, would Lehman Brothers or AIG have gone bankrupt a decade later? In other words, strictly applying rules already on the books, and keeping them there, would help significantly.

It would also help if we could put a stop to overregulation, manage and assist the transition period to introduce new policies— and make that transparent to markets—and embed a risk attitude more than a risk process in all financial institutions. This can be done by fostering diversity of thinking, for example, more stress-testing and scenario analyses within institutions.

One panelist posed a series of important questions: Are there any good regulators out there? The concept of a single banking union is clearly welcomed, but who will supervise it effectively? Is there enough objectivity and sensitivity to local markets? Central banks typically maintain close ties to politics and to a handful of large, often systemic banks. Even the venerable

Collina: Where Are You When We Need You?
Remember Pierluigi Collina, the legendary Italian soccer referee who could control hotheaded players when the stakes were high? He might serve as inspiration when it comes to transforming policy into practice. Consider the following analogies:
  • A good soccer game needs only one referee. Arguably, it better be a good one, but no one would think of carving up the field into sections with a different referee supervising each one.
  • Soccer rules are simple and understandable, though not always easy to measure.
  • A good referee has a yellow card and a red card and knows when to use them—and perhaps more important, when not to. Players understand that violations will be penalized.
  • Referees need to be fit and strong, as they run up as much mileage as the players—and should be treated the same. Errors will occur, of course, but rules evolve with insights, not to correct factual errors.

Think about Collina: Easy to spot, energetic, consistent, unafraid of making controversial decisions but always admired

for being fair, even by those who despised his calls. Applying these qualities to policy making could help it become not only

more practical, but a higher-level game—which is, after all, what society needs.

The Bank of England’s longstanding reputation was tarnished by the run on the Northern Rock bank even as the Financial Services Authority was supervising banks at the time. It seems there is no level playing field across countries and regions, with each supervisor watching local legislation, local interests, and local preferences for analytical tools such as liquidity ratio. Looking ahead, we need a unified supervisory body that will implement practical, consistent policies in a uniform way (see sidebar: Collina: Where Are You When We Need You?).

The need for a single supervisor is widely accepted. The more difficult question is who should take on this role. The obvious choice, the ECB, may have a conflict with its role in monetary policy. All agree the single supervisory system should be non-political and permanent. It should not be just a layer atop the local system, but integrated within the local system. Banks need freedom to choose their business models, as a utility or an innovator, and policies should allow for both. Finally, regulating insurers under a totally different system than that which regulates banks is, in the long term, a bad idea, as many institutions combine both businesses.

Regulation Spawns New Business Models

Participants in the final panel, “New Business Models in the Financial Industry: How can Regulation Influence Them?,” agreed that while policy makers are focusing on better controls to avoid another crisis—and the associated billions of dollars in taxpayer-provided bailouts— industry dynamics are causing unprecedented changes in many segments. The panel offered the example of how both UCITS V (Undertakings for Collective Investment in Transferable Securities) and MIFID II (Markets in Financial Instruments Directive) are affecting the dynamics in asset management. Some distributors will aim to get advice explicitly priced and sold, and fees and royalties between asset-management companies and distributors will become significantly more transparent. As part of local-bank branches, asset managers may evolve from a “manufacturing” platform to become providers of broad investment solutions.

The impact on retail banking is no less inter- esting, noted one panelist. Bank balance sheets will be deleveraged, paving the way for competitors to offer credit—a role traditionally held by banks. Also, payment-services providers could become users of the Internet payment-and-settlement infrastructure (PayPal and Google Wallet), cash-rich corporations may extend credit to suppliers and customers, and securities brokers may work directly with corporations to help them access the bond market. Retail banks, perhaps squeezed out of the professional financing business, will have to learn to advise, structure, select, securitize, and monitor their clients’ activities. And those that seek financing will contract directly with those that provide financing.

As a final example, the insurance-mediation directive has led to more complexity—and, thus, costs—in the insurance-broker industry. Together with technological evolution, this produced the unintended consequence of squeezing services offered. Indeed, increased turnaround speed for quotations has limited the natural capacity of brokers to analyze multiple offers. And the costs and complexity of connections to online quotation engines have reduced the number of inquiries, which in turn has limited consumer choice.

The panel concluded by noting that the challenge for the industry is to tackle the burdens of complexity either by consolidation (which would mean fewer small and local brokers), better information-technology support from insurers, or by portal initiatives. Meanwhile, consumers may believe they are getting more choice when they are actually getting less.

The day’s final discussions explored the implications of prolonged low interest rates on pension funds and insurers, the prospects for future inflation, and the outlook on future business models. Could big data help financial services become more customer-centric? Participants were anxious to discuss possible futures beyond the immediate needs of the crisis, even as they recognized that in this initial phase the industry needs to get back to the basics of managing costs and retaining customers. Perhaps the most meaningful takeaway of the day was this: We need more time before new ideas and expansion can become reality.

A.T. Kearney’s Global Financial Institutions Practice

A.T. Kearney’s Global Financial Services Practice advises financial institutions throughout the world on a wide range of strategic, operational, and organizational issues. Practice members, all experts in their field, enjoy a thriving tradition in financial institution policy making through the Global Financial Services Leadership Roundtable and work closely with A.T. Kearney’s Global Business Policy Council to advance private- and public-sector policy debate worldwide.

Regulatory Fatigue in Financial Services

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