The case for next generation financial regulation 

The case for next generation financial regulation . Photo by Darwin Bell from Flickr.
The case for next generation financial regulation . Photo by Darwin Bell from Flickr.

Two fundamental lessons can be drawn from the current banking crisis. One, we are never done regulating the financial system. To be effective, financial system regulation needs to be periodically reviewed. Two, the forthcoming urgent and fundamental review of the international financial regulatory framework needs to have a conceptual pivot from backward-looking to forward-looking regulation at its core. Climate change provides the most compelling reason for such a pivot.

The demise of Crédit Suisse and Silicon Valley Bank makes the case for periodic review of financial system regulation. 

A critical factor in Silicon Valley Bank’s failure was its over-reliance on government bonds deemed as “financially safe” in what was, at the time, a favourable environment (low inflation and interest rates). It is a good reminder that financial system stability, and core concepts that underpin it (liquidity, risk, market value), are moving targets.  

Crédit Suisse’s story further supports the case for periodic “fit-for-purpose” review of regulation. As recent comments have noted, a failure of regulatory culture was at the heart of the bank’s unravelling. Enacting effective culture of compliance across large and complex global firms is challenging: it requires mainstreaming regulations into a bank’s daily processes, also requiring that the “business as usual” running of a bank remains connected to the initial big picture intent behind a regulatory text. Fighting back “tick-the-box” temptations is first and foremost an internal job, that starts at the top. Regulators, however, play a critical role here, too: when they consider that their job is done, they induce a false sense of continued safety for all stakeholders involved. This feeds tick-the-box behaviour that ultimately weakens risk management. In this sense, it was ill-advised to popularise the current international regulatory framework as the “end-game”.  

Such a fundamental review and reform of existing international rules for the financial system is needed now to ensure climate change preparedness, and at its heart should be a pivot from backward-looking to forward-looking rules and regulatory and supervisory mechanisms.

The current framework is not fit for the global existential threat that is climate change: it was built looking backwards to the Great Financial Crisis, with many core rules relying heavily on standardised computations and historical data sets. This applies to many key existing regulatory requirements and exercises (from the determination of risk-weights to liquidity ratios). The Bank of England recently published a report acknowledging exactly the need for this methodological pivot (highlighting, along the way, the role that scenario analysis can play in this regard).

The success of this methodological pivot depends in large part on the integration of a new tool in the policy toolbox, namely mandatory transition planning. Transition planning is by construction forward-looking. It provides the directionality that financial firms need to intelligently assess risks. It is not necessarily a one-size-fits-all tool, yet a globally harmonised standard can be envisaged to prevent arbitrage. Transition planning should be a mandatory requirement for financial firms – better still, for the private sector generally. It can also be argued that adequate sovereign risk assessment requires some degree of national transition planning. The work done by the UK in this regard will prove critical, as could calls in the US for parallel approaches (such as here, or here). 

Until recently, officials in charge of financial system stability shied away from fundamentally re-examining the existing regulatory framework against the climate challenge, sticking to their “end-game” guns. 

Reviews were conducted. Thus far, they largely put the onus on firms to integrate climate risk into the existing frameworks,

But in the wake of the current banking crisis, official positions are shifting, fast. There is a new sense of urgency, from US Treasury Secretary Janet Yellen to the Basel Committee on Banking Supervision. A reckoning is indisputably underway. The jurisdiction that chooses to champion this issue most strongly in international financial cooperation fora will be the one to reap the political and economic first-mover rewards.       


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