Research Institute of Finance & Banking

People's Bank of China

In the midst of the current financial crisis, the needs for major reform of the global financial system and global financial stability framework have been increasingly recognized. Policymakers and international organizations have made substantial efforts to improve the international financial system including financial regulation and supervision. Various proposals have come forward on priority areas such as redefining the scope and boundaries of financial regulation and supervision, tackling issues of pro-cyclicality in the system, retooling capital and provisioning requirements as well as refining valuation and accounting rules, and some consensus has been reached. Among others, the Group of Thirty has published a Financial Reform report, and FSF and BCBS have undertaken some work on various aspects of financial regulation and Basel II framework. A number of regulators and the financial industry have initiated a centralized clearing and central counter-party mechanisms for OTC derivatives including credit default swaps (CDS). All these efforts will help to fend current crisis and future risks. However, we also note that several issues with respect to the financial regulatory framework have not received adequate attentions. In this note, we would like to explore these issues and provide relevant suggestions.

1. Problems of financial regulation exposed by the financial crisis

The current financial crisis originated from the US subprime crisis, and rapidly spread onto the rest of the world through financial products, financial institutions and markets. The rampant spread of the current crisis demonstrates that issues in the philosophy, effectiveness and international cooperation of financial regulation need to be resolved as effective regulation and supervision is the most powerful external force for containing financial sector risks.

(1)Regulatory philosophy over-confident in self-restraint of market players

In terms of financial regulation philosophy, some developed countries have been heavily reliant on self-regulation of the marketplace, believing in "minimal regulation is the best regulation". In fact, the financial institutions implicated in the Enron and WorldCom debacles and the liquidity crisis troubling some financial institutions in the early stage of the current crisis should have impelled regulators to upgrade supervisions. However, authorities have failed to take much-needed systematic actions. One of the most important reasons for this omission is the conviction that market can correct itself, which led to the overlook of financial sector vulnerabilities posed by the profit-seeking nature of financial institutions. The evolution of the crisis demonstrated that due to the profit-driven nature of market players, market forces, if unchecked, will lead to asset bubbles and ultimately a disastrous market clearing in the form of a financial crisis like the current one, hence wreaking great havoc to global finance and world economy.

(2)Regulatory system need to upgrade timely to avoid lagging behind financial innovations

The developments of the financial crisis have proven that financial innovations have created new sources of systemic risks, such as OTC products and near-bank entities including investment banks, hedge funds and special purpose vehicles (SPVs). These entities, saddled with internal problems and intertwined with traditional financial institutions, are prone to trigger systemic risks. In addition, most financial conglomerates were engaged in non-conventional financial products and businesses to circumvent regulations, which created another source of systemic risks.

The current crisis has clearly shown that the prevailing model of financial regulation lagged behind financial innovation activities. Under the current regulatory model, only deposit-taking financial institutions and conventional financial products with obvious externalities are regulated, while near-bank entities and OTC products are subject to little, if any, supervision. Moreover, financial institutions of different types or domiciled in different jurisdictions, and different products are subject to different regulatory rules and systems. Moreover, the lack of coordination among regulatory authorities has also fostered regulatory arbitrage possibilities. As a result, financial institutions are able to circumvent rigorous regulations and maximize abnormal returns. Different types of arbitrage have hastened the rapid development of near-bank entities and OTC products, and let hedge funds enjoy the treatments from offshore financial centers.