BALANCING THE GOVERNANCE OF THE MODERN FINANCIAL ECOSYSTEM: A NEW GOVERNANCE PERSPECTIVE AND IMPLICATIONS FOR MARKET DISCIPLINE.

• Author: Tsang, Cheng-Yun

Abstract I. Introduction II. Brief Introduction to Post-Crisis Financial Regulation A. Efforts to Enhance Resilience and Rein in Excessive Risk-Taking 1. "Ring-Fencing" Type Reforms 2. Short-term Wholesale Funding Reducing Efforts B. Efforts to Eliminate the "Too Big to Fail" Perception and Improve the Resolvahility of Financial Conglomerates 1. Regulatory Framework of SIFIs 2. Title I of Dodd-Frank: Living Wills and Others 3. Title II of Dodd-Frank: The Orderly Liquidation Authority, Single Point of Entry, and Bail-in Regime C. Efforts to Regulate the Shadow Banking Systems D. Efforts to Revive Prudence and Transform Cultures III. How Should the Financial Ecosystem be Governed? IV. A More Balanced Approach Is Needed V. Through the Lens of New Governance Scholarship A. What is New Governance and Why We Need It B. Features and Principles of New Governance 1. Common Features of New Governance 2. Key Elements of New Governance C. New Governance in the Context of Financial Regulation 1. New Governance and Financial Regulation 2. Limitations of New Governance in Financial Regulation 3. Make New Governance More Workable in Financial Regulation VI. Implications for the Use of Market Discipline VII. Conclusion ABSTRACT

Governance in the contemporary financial ecosystem is very unbalanced. It is neither sincere about nor effective at seeking the collaboration of regulators and all market participants in the exertion of regulatory power, or in the channeling of market force. Nor does it aim to manage the system-wide complexity by balancing its less flexible, prescriptive regulations and the more adaptive, experimental measures. This article maintains that a more balanced governance regime is urgently needed for the modern financial system. It offers a brief but comprehensive review of post-Crisis financial regulations, then identifies the major insufficiencies or limitations of these reform efforts. It proceeds to explore the prospect of using New Governance scholarship to rethink the current regulatory regime, and analyzes how such exploration yields implications for the use of market discipline. It concludes that a well-crafted collaborative standards-setting process that effectively incorporates the New Governance elements of collaboration and experimentation will Bring a much-needed difference to the restoration of market discipline.

1. INTRODUCTION

   Despite the several years that have passed since the onset of the Global Financial Crisis of 2008 ("the Crisis" or "the 2008 Crisis"), many of us have not really recovered from the traumatized economy. Every single agent in today's complex financial ecosystem, be it a retail consumer, banker, financial institution or even regulator, is in some way suffering from economic post-traumatic stress disorder. The ecosystem is itself weakened by this experience and has not yet developed sufficient resilience to sustain future unwelcome distress. The prevailing symptoms include a pervasive distrust of, and disgust with, "ruthless" bankers and "captured" regulators, hyper-arousal upon any potentially harmful financial activity or product, and collective emotional numbness towards, and detachment from, efforts and reforms to make the system healthier. Just like a suddenly-stretched-out slinky, the system responds by locking itself down to prevent any uncontrollable discharge of energy that may lead to another stretch-out. (1) The same situation pertains in today's post-traumatic financial market, where policymakers and reformers choose to respond to the crisis with complex and heightened regulations. We are somehow over-anxious about the occurrence of another catastrophic event, to the point that we would be willing even to overprotect market stability at the expense of market energy and vitality. This level of anxiety is reflected in the post-Crisis financial reforms to the point that the current governance of the global financial system remains unbalanced in its engagement of regulatory power and the market force. The focus of financial regulation is somehow either too hostile to industry practices, or too excessive in its use of regulatory powers.

   This imbalance was created essentially by the confrontation of two fundamental forces: (1) the growing public distrust of banks, on the one hand, that all but destroys the possibility of regulators harnessing the "good power" in the industry to serve the common good; (2) and (2) the growing complexity in banking and finance, on the other hand, that renders the intention of safeguarding financial stability with "pure" regulation an essentially impossible mission. (3) To make things worse, public distrust is deepened by the escalation of complexity, and complexity is never reduced in the absence of trust. We cannot help but wonder if this is really how finance and banking have to be governed.

   Heightened regulation may have the potential to maintain financial stability but will not necessarily do anything to restore the trustworthiness of the industry. After all, regulation in itself is suggestive of the very fact that industry members cannot be trusted completely, and it implies that the financial market cannot function without encountering failures. Can governance of the financial ecosystem be redirected to a path where the resilience of the system is enhanced, and not too much complex regulation and social distrust intrudes? This author is of the view that there is an affirmative answer, and it probably lies in better market discipline managed by the novel governance regime in which regulators collaborate extensively with the regulated.

   Specifically, the post-Crisis system of governance has failed to balance at least the following of its aspects: (1) the use of regulatory weapons and market power; (4) (2) the use of prescriptive regulations and experimental measures; (5) (3) the one-size-fits-all and individually tailored approaches; (6) (4) the choice of a strictly observed schedule or an adaptive, flexible process for implementation; (7) and (5) the use of complex preventive rules and simple forward-looking principles. (8) These issues compound to formulate fundamental inquiries: How should financial markets be governed? Specifically: how should we regulate financial markets and craft regulatory regimes? Should we stay with the traditional command-and-control approach, or adopt a shared governance regime in which regulators and the regulated collaborate and learn together? Is there an optimal, or better, governance regime for the contemporary financial ecosystem? Is the post-Crisis financial regulation heading in the right direction? This article aims to explore these questions and provide tentative answers to them.

   Part II conducts a brief but comprehensive review of post-Crisis financial regulations, then identifies the major insufficiencies or limitations of these regulations. That analysis will further support this author's conviction that a more balanced regime of financial governance is urgently needed. Part III explores further the possibility of using New Governance (NG) theory to reconstruct the current regulatory regime. This exploration will pave the way for the discussion of market discipline, a key building block of the more balanced governance regime this author envisages. The final section of Part III will analyze the implications of New Governance methodology for the practicing of market discipline. Part IV concludes.

2. BRIEF INTRODUCTION TO POST-CRISIS FINANCIAL REGULATION

   It is fairly important to understand the current development and direction of the post-Crisis financial regulations. (9) Such an understanding will shed light on the ongoing financial reforms, and most importantly, it will demonstrate why this author believes that restoring and enhancing the self-disciplinary power of the market is what the world of finance needs urgently. To briefly introduce the post-Crisis regulations, this author finds it helpful to categorize them into four groups, according to their different regulatory objectives: (1) Efforts to Enhance Resilience and Rein in Excessive Risk-Taking; (10) (2) Efforts to Eliminate the "Too Big to Fail" Perception, and Improve the Resolvability of Financial Conglomerates; (11) (3) Efforts to Regulate the Shadow Banking Systems; (12) and (4) Efforts to Revive Prudence and Transform Cultures. (13)

   Discussion in this Part will be limited to the official regulations and regulatory proposals made by the authorities and will not engage with scholars or other commentators. Also, this discussion will be concentrated on the regulatory efforts of international agenda and standards setting bodies such as the Financial Stability Board ("FSB") and the Basel Committee on Banking Supervision ("BCBS"). A few local regulations, mostly those of the U.S., and only those of other sovereigns (the U.K. and the EU) that this author deems significant per se or more sensible than a comparable U.S. regulation will be covered.

   1. Efforts to Enhance Resilience and Rein in Excessive Risk-Taking

      The idea of enhancing resilience in the financial system has gained popularity in the aftermath of the Crisis. "Resilience" in the context of financial regulation can be said to carry a two-dimensional meaning. It refers to the broad system's capability to regain its original shape after a systemic shock, and to the individual firm's capability to regain its original shape after an idiosyncratic failure or system-wide meltdown. (14) These two dimensions suggest that policymakers have to take into account both the micro--and the macro-level regulation and supervision. Ordinary capital requirements, leverage ratio limits, liquidity regulations, and systemic surcharges are all the kinds of regulatory measures that serve this end. (15) Theoretically, the more common equity and liquid assets a financial institution has, the more resilient it will be when experiencing an external shock. (16) Generally speaking, effort aimed...