Strengthening financial regulation for stability

Chiara Oldani, professor of monetary economics at the University of Viterbo ‘La Tuscia’, writes on the fragility of financial markets and the measures that can be implemented to mitigate risk

The main risk to financial stability in 2019 is growing market segmentation that could fundamentally affect the delicate equilibrium achieved after the global financial crisis. That crisis forced western countries to cooperate and improve financial regulation in order to restore confidence and trust. Global financial regulation in the European Union and United States converged until 2016, when the United Kingdom voted to leave the European Union with its common market and prudent and stringent rules.

Then, in the United States in 2017 President Donald Trump announced his rejection of the Dodd Frank Wall Street Reform and Consumer Protection Act. A year later Congress approved a substantial change to the prudential rules introduced in 2010. Now, any financial institution that has total assets in excess of $250 billion – instead of $50 billion – would be considered systemically significant; this higher level allowed many institutions to lend and trade with less supervision and capitalisation. This freedom is necessary to acquire more market share, especially in the digital banking and fintech sectors that are spreading in G20 members.

Today, financial stability has been restored but at a high price: higher unemployment and public debt, and reduced consumption. Extraordinary expansionary monetary policies have led to zero-interest rates and alleviated the credit crunch, but they have also reduced revenues in the financial industry and pushed the need to innovate, find new businesses and circumvent rules.

The Financial Stability Board has greatly contributed to the improved resilience of the global finance sector, but its duties are not over, as its new chair Randal Quarles said in Brussels in April 2019. In December 2018, the notional value of over-the-counter derivatives reached $544 trillion, and about two-thirds of OTC interest rate derivative contracts are cleared by central counterparties that are often systemically important banks, according to the Bank for International Settlements.

In fact, the introduction of centralised counterparty systems for OTC derivatives in 2008 reduced the counterparty risk, but increased concentration in the industry – as G20 leaders noted at their first summit in Washington in 2008. Higher market concentration can represent a new source of systemic risk, since the relationship between banks and central counterparties is highly symbiotic.

The growth of non-bank financing – that is, services such as loans or credit provided by financial institutions that are not licensed – deeply modifies the structure of the market and the financial industry. According to the BIS, fintech credit volumes are greater in G20 countries with less stringent banking regulation, particularly in China, the United States and the United Kingdom. Sustained demand for digital currencies such as bitcoin or Ethereum is also the result of reduced regulatory coordination among G20 members that does not substantially impede their trade.

The FSB should work with G20 authorities to reduce market fragmentation in traditional finance, because such fragmentation can weaken supervision and monitoring, and thus bring certain risks to stability. It should enhance leaders’ responsibility regarding the non-traditional finance and banking sectors that pose problems with respect to consumer and investor protection (for example, with regard to money laundering, fraud and data protection).

Increased regulation affects innovation, so the most efficient and feasible solution cannot be a global regulator; instead, G20 finance ministers and central bankers meeting in Fukuoka shortly before their leaders meet in Osaka should identify common incentives to efficiency and competition. Together, they can drive future policy proposals and achieve stability.