Prudential Stability & Blockchain

Prudential Stability with Blockchain

In order to understand why FinTech could be a probable solution, we will need to examine the roots of prudential regulation. Prior to defining prudential regulation, we need to first introduce the term “macroprudential.” Introduced by the Bank of England [BoE] and Cooke Committee [predecessor to the Basel Committee] in June 1979 in a meeting about maturity transformation of cross-border lending practices (Clement, 2010). Although the term had been used in several financial crises i.e the Asian Financial Crisis, it was left unexamined for the greater part of two decades. It found an increased amount of adoption after the financial crisis of 2007-2008 which saw central banks’ balance sheets wiped out immediately. The aftermath of the Great Recession had many economists adopt a two-pronged solution under the umbrella term of Prudential [Prudent] Regulation. Macroprudential or macroprudence in regulation has the explicit goal of achieving a stable economy by reducing the costs of macroeconomic events in form of financial crises, sanctions, war. Macroprudent regulations act as the bridge between sound macroeconomic policy and microprudential regulations of firms and financial intermediaries (BOE, 2009). Even till today the term hasn’t achieved a fixed definition but has been agreed on by many to mean a supervision framework with regards to the general macroeconomic environment with the ultimate goal of reducing systemic risk.

Some background
One decade after the start of the Great Recession, policymakers have several macroprudential tools that can be deployed when required. Many of these financial metrics exist to limit exuberance and are heavily focused on procyclical “suppression.” One key matrix is the max loan to value ratio and levy on noncore liabilities. Macroprudential risks and believed to be controlled through application of such macroprudent regulations. Regulators started expecting higher liquidity, implementing penalties on excessive risk-taking and enacted internal policies on forced haircuts on Asset-Backed Securities.

And?
It would not be complete to discuss macroprudential regulation without Basel III. This latest accord would reflection the strictest and conservative macroprudential thought of our time. Improved on Basel II. Basel III most notably increased the capital requirements of financial institutions such as banks to ensure that these institutions would not face the credit and liquidity issues for which they experienced most notably post the Lehman Brothers crash. In those days, financial institutions held onto as much liquidity as possible and banked extremely conservatively. Distilled to its essence, Basel III attempts to transfer the externalities of the financial institution back to their own “books” through increasingly higher capital requirements which ranged from the minimum capital to a fully protracted “Conservation buffer” for which more liquidity is set aside to meet capital adequacy demands. In addition to capital requirements, Basel III targets the liquidity coverage ratios and implements a cap on the total leverage of such institutions (BIS, 2017).

Improved communications and cooperation have allowed macroprudential policies to flourish. Although macroprudency has been popularized in the past decade it is Microprudential Regulation that has helped the economies globally remain financially sound. Microprudential regulations are firm-level regulatory requirements which help firms [chiefly banks] remain operational as contagion spreads around in a financial system. A microprudentially sound financial institution or firm is highly resilient to changes in the economy and tends to defend well against speculative attacks in credit crunch situations. Microprudential regulations are mainly focused on shoring up of balance sheets and places an importance on countercyclical actions. The BIS defines microprudential as “use of prudential tools with the explicit objective of promoting the stability of the financial system as a whole…” (Clement, 2010).

Rationale of Prudential Regulation
In 2011, OECD researchers Slovik & Cournède found that the combined economic impact of increased regulation, with Basel III leading the charge, would be a 0.1% decrease in GDP growth per year (Slovik & Cournède, 2011). The Basel III accord attempts to address some of the systemic risk faced by regulators during crises and hopes that this additional voluntary protocol can help cushion the blow in upcoming financial crises.

The above cases have shown that we need some form of systemic accountability which happens to occur in form of prudential regulation. However, what is the rationale for Prudential Regulation? Regulators and analysts require prudential regulation for three problems.

Principal-Agent Problem
also known as the agency problem. Carries with both macro and micro implications. Firstly, the presence of moral hazard with both retail and investment banks expecting central banks to step in to intervene as the lender of last resort. This can be observed in Lehman Brother’s collapse during the Great Recession for which most participants had expected that Bernanke would step in, utilizing the powers accorded to it through Section 13a of the Federal Reserve Act. Chair of the Fed Bernanke and US Treasury Secretary Paulson instead tried to broker a deal between other banks knowing fully well that U.S. taxpayers will not be able to stomach a bailout of Lehman. The brokered deal did not go according to as planned and Lehman Brothers Holdings Inc. filed for Chapter 11 on September 15, 2008. This debacle has shown that this separation of ownership and management meant that firms in such as situation needs to rely on the regulator to do the “cleaning up.” After adopting policies that had them levered up to their necks. The microprudential part of the agency problem can be explained using the bailout of Fannie Mae, Freddie Mac, and AIG. The latter’s bailout package occurred the next day. On September 16, 2008, the United States government seized AIG after providing it with a USD 85 billion bailout package. Prior to the Lehman failure, on September 6, 2008, the US government took over control of both Fannie Mae and Freddie Mac citing financial health concerns

Agency Problems
It stands that it was an error on Lehman Brothers’ part to assume that the Fed would step in before its collapse. It too was a problem over at the Treasury’s/Fed’s end. How did they decide which institution or firm was to receive aid from the Fed or Treasury? Was Lehman Brothers allowed to fail due to their smaller market capitalization, in contrast, AIG with its massive market capitalization is too big to fail? Regardless, this formed a strong basis for increased oversight and prevention measures through prudential regulation such that regulators need not have to face such on-the-fly decision making in the first place.

Prudential policies
Prudential policies are subject to rent-seeking behaviour in forms of lobbying and manoeuvring. Secondly, current prudential regulations exist only to shore up defences against the next financial crisis. It is public knowledge that no one can predict the future and as such have no true idea if these improvements could stand up to the test of time, or would even be implemented at all. This paper proposes taking a quick look at current improvements in the field of financial technology and its increased applications in order to serve the same financial institutions that were trapped during the Great Recession attempts to address these problems in a complementary way. Critics can argue that the main value proposition of FinTech is to bring more dollars and cents in terms of revenues to the very financial institutions that are applying it. However, unknowingly, they are also funding the reduction of asymmetric information. And as we shall review in upcoming posts, bring greater security and scrutiny to traditional banking.

-Cryptoeconomics.Asia