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Back to basics

By Andrew Sheng (chinadaily.com.cn)
Updated: 2008-11-17 10:23

Focusing on the real sector means that greater attention will have to be paid on the housing market as one of the key pillars of social stability, to ensure via appropriate government policy that there is adequate supply and that housing is affordable to the majority of the population on a sustainable and equitable basis.

The mistake in Basel Accord was to exercise social policy through regulatory forbearance, by giving credit to housing a lower than appropriate capital weighting. We must have dynamic credit provisioning and better use of Loan-to-value ratios in preventing credit excesses to finance real estate bubbles.

For emerging markets, I draw two immediate conclusions from the current crisis. The first is that the universal banking model has serious problems for two fundamental reasons. One is that you cannot mix the culture of investment banking (where risk taking is key) and commercial banking (where prudence is vital) under one roof. Glass-Steagall was not fundamentally wrong.

The other is that not every banking system can become totally wholesale – the bulk of the banking system must remain retail and therefore concentrate on what Main Street banking does or should do well – protect the interest of depositors and serve the bulk of the corporate sector, especially small and medium-sized enterprises that provide mainstream employment in the real economy. It is no longer about quick money, but long-term term returns on a safe and steady basis.

The fourth key lesson is that even though unregulated financial innovation was at the heart of the current crisis, we cannot conclude simply that all financial innovation is bad.

The plain vanilla type of mortgages and mortgage-backed securities are performing relatively well in the US and markets such as Hong Kong and Malaysia. Asset securitization can become the backbone of a robust corporate bond market in Asia as well as means of reducing the maturity mismatch of the banking system when it finances home-ownership.

Just as there is a national drug administration to vet and approve new drugs, there is no inherent reason why financial regulators should not examine, approve and exercise proper due diligence on new financial products. As long as such products do not have systemic implications, they can be traded on an over-the-counter basis.

But once these products reach a certain level of scale, these should be moved onto net clearing arrangements with centralized counter-party arrangements to monitor counterparty risks and levels of leverage. Opacity is fine for private modesty, but where public health is concerned, transparency and regulation is necessary.

Fifthly, the whole philosophy of financial regulation and the way it functions within the financial stability policy function needs to be examined. The recent trend towards creation of financial super-regulators was due to the concentration and conglomeration of the financial industry itself.

The present institutional basis of financial regulation created multiple regulators, making the coordination and enforcement of supervision complex, costly and less effective. One of the arguments for super-regulators was that costs to the industry were too high.

The answer is now obvious. Higher costs of regulation to LCFIs were still cheaper than the costs of crisis to the public. Hence, it is not the cost of regulation to the industry that counts, but the total social costs (including prevention of innovation and crisis) that matters.

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