Rule-making for systemic risk

April 14, 2021

One of the first things I learned when I began working as a lawyer on Wall Street in 2007 was the concept of a “write-down”.  I started to understand it more clearly about a year later when I starting representing creditors of Lehman Brothers.  This allowed me to learn a lot about debt, balance sheets and complex financial instruments.  One of the most instructive parts of this was learning about fair-value accounting and how this can have a critical impact on the strength of a financial institution’s balance sheet. 

Fair-value accounting basically involves revaluing an asset at its market value on a quarterly basis.  It was criticized a lot after the financial crisis, but is it really to blame for all of the bank failures?  Fair-value accounting actually provides a much more realistic view of the value of a security than looking at the asset at the time it was purchased, i.e., historical cost accounting. 

But fair-value accounting didn’t take into account the scenario that many of the assets in question would experience a simultaneous devaluation and the systemic risk that that would create.  And unlike today, there was no rule that addressed what to do in that scenario. So we learn that just because a rule is good for a company on a stand-alone basis does not mean it is good for the financial system as a whole. 

A good systemic rule needs to have some measure of flexibility built into it.  It is worth noting that accounting standards become “regulation” in different ways in the United States and Europe.  In the United States, accounting standards become applicable unless overridden by the U.S. Securities and Exchange Commission.  In Europe, the opposite is true; accounting standards must be “endorsed” by the European Parliament, the European Commission and the EU Council of Ministers before becoming law.

This meant that around the same time that Lehman Brothers went under, the European Union allowed banks to shift their bonds and marketable loans from fair value to historical cost “under rare circumstances.”[1] Thanks to this change, European banks increased profits by an estimated $29 billion in 2008.[2]  That’s a good outcome.  So a good rule also needs to have the right amount of flexibility built into it; allowing a regulator to step in and examine whether a rule is creating a good outcome is one way of doing that.

One of the outcomes of the financial crisis, whether good or bad, was an increased focus on rules.  Some rules were rooted in process, some rules were driven more by the types of products in question and some rules were driven more by the level of regulatory oversight that was deemed necessary after the crisis.

Many of these new regulatory requirements related to more granular reporting in the hopes that greater disclosure would help mitigate systemic risk.  Transparency is certainly a good thing for markets, but would greater disclosure on mark-to-market risk have prevented the banks from writing down their balance sheets?  No, it was a systemic risk that would have probably been best identified by a regulator. 

Companies have particular relationships with regulators and this varies greatly depending on the countries in question. In my experience, the risk of bad outcomes is much stronger when the public and private sectors do not communicate enough or at a level that allows each to understand the other’s objectives and rationale. The worst outcomes are created when companies are fearful of engaging at all. So good rules also need good engagement.

One important point that I have learned in the years I spent working in the financial and energy industries is that we are quickly moving towards a system of transnational private regulation.

This means that private actors are increasingly required to take “regulations” to the next level of granularity through adopting their own policies, procedures and processes to ensure that laws are appropriately respected.  Private actors are also increasingly required to enforce these policies, procedures and processes vis-à-vis their own third-party business partners, whether it be clients, customers, suppliers, distributors or otherwise. 

One of the risks associated with this approach is that companies spend more time on compliance than on the quality and safety of their operations. Another risk is that the policies become purely window-dressing, with no real regard for studying systemic risk.

That said, this approach also represents a certain opportunity. To the extent that rules are drafted by people that know the business well (the good, the bad and the ugly), allowing more self-regulation could give way to simpler, more meaningful risk management.

With this in mind, making sure that rules are most appropriately designed to create good outcomes and allowing enough flexibility for regulators to interrupt bad outcomes becomes even more important.

CPM

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[1] See Official Journal of the European Union, Commission Regulation (EC) No. 1004/2008 of 15 October 2008 amending Regulation (EC) No 1725/2003 adopting certain international accounting standards in accordance with Regulation (EC) No 1606/2002 of the European Parliament and of the Council as regards International Accounting Standard (IAS) 39 and International Financial Reporting Standard (IFRS) 7.

[2] See Robert Pozen, Is It Fair to Blame Fair Value Accounting for the Financial Crisis?, Harvard Business Review, Nov. 1, 2009.