After the Crash: The Future of Finance

3. Regulatory Changes and Investment Banking: Seven Questions

53 3 kei kodachi tetsuya kamiyama Regulatory Changes and Investment Banking: Seven Questions Work is currently going on under the auspices of the Group of Twenty (G-20) to reform the international financial system to prevent a recurrence of the present global financial crisis. The G-20 identifies the root causes of the crisis and voices its concern about financial sector practices as follows: “During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices , increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system.”1 The G-20 has set the goal of learning lessons from the crisis while at the same time dealing with a host of issues. These include improving the regulation and oversight of systemically important institutions, enhancing macro–prudential policy, improving international cooperation among supervisors while harmonizing bankruptcy frameworks for financial institutions, mitigating against procyclicality in regulatory policy, and reviewing compensation practices as they relate to incentives. The group is also drawing up a list of reforms to be implemented in 1. Group of Twenty (2008). 03-0404-1 chap3.indd 53 7/12/10 6:01 PM 54 kei kodachi and tetsuya kamiyama the near future. Thus investment banking, if the G-20 reforms are adopted, will be much influenced by regulatory reforms.2 Questioning Some G-20 Reforms Although we agree with the aim of the G-20—preventing a recurrence of the present crisis—some of our views on the direction the reforms should take differ from those of the G-20. In particular, we question the need for the following eight reforms relating to investment banking. —Is increasing regulatory capital an effective means of preventing another crisis? —Is there any need to increase capital requirements for trading books? —Is the simple leverage ratio requirement appropriate? —Does the market for structured products need more rules? —Are the rules governing over-the-counter derivatives appropriate? —Are the rules governing short selling appropriate? —Do hedge funds need to be regulated? Is Increasing Regulatory Capital an Effective Means of Preventing Another Crisis? The present global financial crisis stemmed from the subprime mortgage crisis in the United States. Banks raised money from foreign sovereign wealth funds and other private sector sources during the initial phase of the crisis but were later obliged to accept injections of public money as the crisis deepened. Before the crisis many banks met minimum capital requirements but later were short of capital. It therefore seems that increasing the banks’ regulatory capital has become the most important item on the G-20’s agenda of financial reform. However , we ask, will a higher level of regulatory capital prevent another crisis? We consider this question from several perspectives: maturity transformation and market liquidity, turmoil in liquidity markets, asset price effects, fire-sale externality , and capital buffers. Maturity Transformation and Market Liquidity The present financial crisis was probably caused not only by an impairment of bank assets both on and off balance sheets but also by a depletion of market liquidity on a global scale (namely market-oriented systemic risk). Examples of market-oriented systemic risk include the stock market crash of 1987, when stock markets malfunctioned and share prices fell sharply; the 2. Unless indicated otherwise, bank should be understood to mean either a commercial bank or an investment bank. 03-0404-1 chap3.indd 54 7/12/10 6:01 PM seven questions on financial reform 55 Long-Term Capital Management crisis of 1998; and the junk bond market turmoil of 1989–90, when interest rate spreads widened and liquidity declined.3 The reason attention has switched from bank runs to market gridlock as a cause of systemic risk is probably that, since 1990 or so, the importance of the market -based financial system (the role of markets in financial intermediation) has increased relative to that of the traditional banking system.4 As a matter of fact, U.S. flow-of-funds data show that market-based assets exceeded bank-based assets before the present crisis (figure 3-1).5 3. Hendricks, Kambhu, and Mosser (2007) deals with the differences between systemic risks to banking systems and systemic risks to market-oriented systems. 4. U.K. Financial Services...