At this Friday’s summit in Pittsburgh, the G-20 leaders will engage in the usual mix of photo ops, gourmet luncheons, backslapping and some real work. They and the world would be better off if this ‘real work’ of reforming the world financial system was informed by some sound principles.

In a debate that has bordered on being shallow and shrill, approaching regulation with a view to increasing the competitiveness, diversity and fairness of the financial system at the same time as reducing its complexity would be the only sensible route to take.

Competiveness

Years of 20%-25% return on equity for banks, 2/20 % hedge fund fee structures, $50-$100 billion in annual bonus payouts and, until recently, a large and growing share of corporate profits are signs of too little competition in the financial sector.

Current regulations favor big institutions over small, international banks over domestic banks, and complex ones over simpler rivals. This asymmetry, economies of scale and the public subsidy that institutions considered ‘too big or too complex to fail‘ enjoy has driven the trend towards ever-greater consolidation into financial giants with few, if any, new entrants. The shotgun bank weddings and government-financed takeovers of weaker institutions has further exacerbated this problem.

The high rewards available to employees and shareholders in this oligopolistic system and the protection against failure for large institutions skew incentives and encourage speculative and destabilizing behaviour. Barriers to entry need to be lowered and financial institutions need to be broken up so their failure no longer poses a threat to the system.

This would not only deliver a much better deal for customers and investors but also for taxpayers since such a system would also be less likely to crash.

Diversity

Soldiers crossing a bridge are asked to break step else the bridge would become unstable and collapse. When everyone wants to buy or sell at the same time we get asset price bubbles and collapses.
We need the whole range of financial institutions — savings banks, insurance firms, investment banks, and pension funds — doing what they are supposed to do. When banks behave like hedge funds and hedge funds like banks, we have a problem.

Current regulation allows market prices and institutions’ own judgment of risk to influence how much capital they hold. Since this capital is held to guard against market failures in the first place, there is a big contradiction here. This, together with the use of similar risk management and bonus incentive systems across institutions which all have access to the same data drives everyone to invest in the same assets at the same time and reduces diversity. It has made the financial system more pro-cyclical, unstable and prone to systemic collapse.

Financial institutions need to be regulated by function not legal form. Capital requirements need to be mandated by regulators, not markets or their own judgment. Diversity can come from different investment horizons, incentive systems, risk appetites, risk management approaches or regulatory requirements.

Simplicity

Because current financial regulation is reactive, efforts to ‘fine tune’ and adjust it have left us with tens of thousands of pages of rules which are full of loopholes but act as a barrier to entry nonetheless. These differ across jurisdictions and legal form financial institutions set up a complex network of hundreds of subsidiaries to game the system. Behemoths such as Citicorp which has more than 2,000 subsidiaries (427 in tax havens) are not only too complex to fail but also too complex to manage.

We need to hardwire simple and blunt regulation such as caps on leverage, country by country reporting and prohibitions of off balance sheet exposures.

The parallel rising complexity of financial products is driven by the fact that complexity increases profit margins and opportunities for regulatory arbitrage. It does so by increasing information asymmetry between the financial institutions on the one hand and its customers and regulators on the other. Complexity in legal structures and products also reduces transparency and supervisory effectiveness increasing systemic risk.

Regulation needs to aim at simplicity in legal structures and financial products.

Fairness

Large banks excel in reducing the tax burden on themselves, their employees and large customers through the use of complex products and legal structures often involving tax havens. In good times they do not pay their fair share of taxes and in bad times such as now depend on tax payer funds. This is not only unfair but even more important destabilizing since it encourages excessive risk taking.

Financial polluters must be made to pay so there is an urgent need to crack down on tax avoidance by banks, bankers and their clients. The costs of ongoing and future bailouts must also be recovered from the financial sector through levying financial transaction taxes. These are easy to collect, hard to avoid, have a very progressive incidence, have the potential to increase stabilit,y and can even be implemented unilaterally.

Compensation in the financial sector needs to be regulated sharply downwards to make it more symmetric. Current annual bonus structures drive short-termism, speculation and irresponsible behaviour because such behaviour can be highly rewarding.The only problem is that eventually the taxpayer has to foot the bill!

Sony Kapoor is an ex-investment banker who is now the Managing Director of Re-Define www.re-define.org , an International Think Tank. He is also an adviser to several governments and international institutions on financial system reform. A version of this appeared as an Op-Ed in the German newspaper Sueddeutsche Zeitung on the 15th of June 2009