The False Security of Complex Financial Regulation - and What to Do About It

In the wake of a series of crises, international and domestic financial regulation has become highly complex and prescriptive, but doesn't address the fundamental issues behind the crises, according to a report released today by the C.D. Howe Institute. In "Shareholder Liability: A New (Old) Way of Thinking about Financial Regulation," author Finn Poschmann finds the regulations ignore history and human behavior. He recommends greater reliance on an incentives-based approach for financial institutions, which shares the risks among bond buyers, shareholders and depositors, as a better backstop to financial stability.

"The new regulations in Canada, the US, and Europe are oriented to leverage, liquidity, and capital ratios among financial institutions," notes Poschmann. "This raises concerns over monitoring incentives, and over the increased role of deposit insurance, which insulates depositors and shareholders from some or most of the costs of an institution's failure." Poschmann examines the role of an incentives-based approach in the past century when banking regulation relied mostly on monitoring by shareholders and depositors. Senior bank managers often were exposed to liability for net losses incurred in the event that their financial institutions failed, as were other shareholders, he notes. Bank depositors therefore were nearly always made whole, and financial crises tended to be sharp, brief, and localized. Shareholder liability has long disappeared, and is unlikely to return. Poschmann recommends instead that modern regulators should focus more on incentives. Equity-based market instruments, such as equity recourse notes, a market-based form of contingent capital, could achieve shareholder liability's good effects by sharing risk with bond buyers and shareholders. Poschmann also warns that growing provincial reliance on deposit insurance raises concerns. A number of provinces have expanded the size and range of deposits they cover, and British Columbia, for example, has joined Alberta, Saskatchewan, and Manitoba by introducing unlimited deposit insurance. This expansion will pose stability risks for the provinces that oversee the insurers, and for regulators and depositors outside those provinces. Implicit and explicit federal backstops for such insurance raise cross-province concerns.

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Provincial deposit insurers should reduce their deposit coverage, and converge on a common standard at the federal level, $100,000 per account. Further, a recently announced transitional expansion of federal deposit insurance, designed to cover deposits at credit unions that migrate from provincial to federal jurisdiction, should be withdrawn at the earliest opportunity. For the report, click here: James Fleming, M.A. Editor, Vice President, Media C.D. Howe Institute