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From Banking and Finance Law Daily, October 15, 2014

Summit to be too big to fail “watershed,” regulator says

By Richard A. Roth, J.D.

The November summit meeting in Brisbane, Australia, will see the adoption of Financial Stability Board proposals that will be decisive in ensuring that financial institutions bear the costs of their own actions, FSB Chairman Mark Carney is predicting. While international regulatory improvements already have brought about substantial progress in strengthening the global financial system, the necessary changes cannot be considered to be complete until the perception that institutions can be too big to fail is ended, Carney told the 29th Annual G30 International Banking Seminar.

Carney pointed out that since the financial crisis, regulatory changes have made financial institutions more resilient, increased capital requirements, made derivatives trading both safer and more transparent, and set liquidity standards. However, the ongoing problem of too-big-to-fail “undermines market discipline and goes to the heart of fairness in our societies,” he said. “This cannot be allowed to continue.”

Too big to fail. It won’t be easy to end the “rampant moral hazard” in the financial system, Carney conceded, and it won’t be possible to completely insulate all financial institutions from all external shocks. However, it is essential to ensure that any failing financial institution be resolved without the need for a taxpayer bailout and without broader disruption to the system or the economy.

Two proposals aimed at this will be presented in Brisbane, Carney said:

  1. An international standard on total loss absorbing capacity for globally systemic banks should be adopted. The standard will include clear requirements for the amount, type, and location of that loss absorbing capacity.

  2. The total loss absorbing capacity agreement will be strengthened by the recent agreement among derivative-dealing banks to change their standard cross-border derivative contracts to provide a short-term stay if a global bank fails. This will end the risk that foreign counterparties will “take their money and run,” Carney noted.

Rebuilding trust. The G20 has a second objective, according to Carney—rebuilding trust in an open, global financial system. He described three elements necessary to that process.

There must be “intensive co-operation” among national financial regulators. While national authorities must retain some ability to respond to local conditions, they must not use domestic rules to protect their own markets at the expense of the global system.

International regulatory actions must be subject to “rigorous and transparent peer review and assessment,” Carney said. This will not only ensure that agreed-upon standards are being implemented but also that adverse unintended consequences of those standards are avoided or mitigated.

Also, regulators must be alert to new and emerging system vulnerabilities, he advised. Currently, these are arising from the housing markets; the financial markets’ reach for yield in a low interest rate environment; and the growth of the asset management sector as a portion of the global economy.

Rejecting fatalism. Reform efforts must not be slowed by arguments that regulatory requirements can be avoided by arbitrage, that any insurance will promote undesirable risk-taking, or that stability impedes growth, Carney urged. While financial crises cannot be completely prevented, the changes in progress will make crises less frequently and less damaging, he asserted. Reform and regulation will encourage, not block, growth.

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