Can financial regulation avoid a new systemic crisis?

It is almost 10 years since the global financial crisis, but many countries are still recovering from the mayhem.

The financial systems havoc can be traced to the US and European banks and governments for allowing lower income groups to borrow at sub-prime rates.

In the aftermath of the economic crisis governments began a process of changing and strengthening regulatory and risk management.

According to EY, the crisis demonstrated the scale of costs that can arise from insufficient or poorly designed regulation.

Unfortunately, the slowdown in international capital flow resulted in the collapse of share prices and the exchange rate coupled with the control of inflationary pressures coming from raising oil and food prices resulted had a negative impact on the financial sector.

The sudden difficulty and increasing cost of accessing international source of financing slowed down infrastructure investments, especially in the energy and mining sectors, with long term negative consequences for the development of growth capacity.

This highlighted the need for many countries to implement stringent regulatory regimes that would prevent this type of risks from happening again.

Although it took almost 10 years, the South African government decided to take steps to strengthen its supervision and market conduct. The government is implementing the Twin Peaks model that will create two main regulators to preside over the financial system: the Prudential Regulator, which will form part of the Reserve Bank, and the Financial Sector Conduct Authority, into which the Financial Services Board (FSB) will evolve.

One of the key objectives of implementing a Twin Peaks model is to maintain financial stability.

The strengthening of the resolution framework with the implementation of Twin Peaks will assist in managing the failure of financial institutions and mitigate any negative impact on South Africa’s financial stability while minimising macroeconomic costs.

Moreover, The Reserve Bank is developing a toolkit to tackle systemic risk to the financial system, it said in July.

EY’s prudential partner Vibhuti Lalloo said within the Twin Peaks framework, the Financial Stability Oversight Committee (FSOC) will be established to ensure co-ordination and co-operation across the authorities, permitting the authorities to work together with the Reserve Bank in managing the effects of a systemic event. The FSOC will also advise on the designation of systemically important financial institutions (SIFIs) and matters relating to crisis management and prevention. Regulations focused on stability include the Special Resolution Bill which concentrates on ensuring the continuity of SIFI’s, the protection of depositors, as well as minimising destruction of value and cost to home and host jurisdictions. In addition, the responsible lending requirements under the National Credit Act, will provide an additional tool towards financial stability. “All of these, together with monitoring mechanisms, will form part of the SARB’s objective to maintain financial stability,” says Lallo.

EY adds in one of its reports that the focused remit of separate regulators should enable the strengthening of both prudential and market conduct supervision. This will include a more pre-emptive supervisory focus and a reduction in the potential of systemic risks crystallising within the financial system.

Systemic risk is when the failure of one organisation leads to severe instability or even collapse of the entire industry. Technology is increasingly being seen as a risk as a result, regulators are also looking at ways to leverage new technology and analytics to better manage systemic risk and large amounts of data, says Accenture.

The consulting firm adds that as the financial services industry has become increasingly reliant on technology, regulators have signalled concerns about the industry’s ability to handle technological challenges. The capacity of financial institutions to manage their existing IT infrastructures, cope with the changes taking place and address growing cybersecurity risks is being closely scrutinized by regulators.

“Regulators now view technology as a systemic issue with direct implications for the viability of both financial services companies and the financial system. This was brought home during the financial crisis by the run on Northern Rock in 2007. The immediate cause of the run was not the bank running out of cash but inadequate server capacity as desperate customers tried, and were unable, to withdraw money online,” Accenture states in a report on Bridging the technology gap in financial services boar drooms.

The implementation of the Twin Peaks model should go a long way toward preventing financial crises like the subprime mortgage problems.