Peter Guy, Regulation Asia, January 18, 2016
peter@inasiamedia.com

The next regulatory crisis could be echoed in dire research reports.

The next financial and economic crash could be worsened by ill-conceived, poorly implemented regulations that are now as much a part of the problem as they are a solution.

In a recent research note sent to its clients, analysts at the Royal Bank of Scotland warned that markets face a “cataclysmic year.” They predict equity markets could fall by 20%.

The report described events so profound that they would force investors to think about “return of capital not return on capital”. Deflationary worries are also heightened with WTI and Brent crude hitting fresh lows last Friday, dipping below USD30 a barrel – their lowest prices since April 2004, over persistent fears of oversupply.

If a 2008 style meltdown repeats itself, it will be differentiated and complicated by China’s substantial role in the global economy, its debt levels and regulatory shortcomings. While liberalising the yuan and its own markets, China is also trying to introduce economic and monetary policies at a hazardous point where global markets face severe pressure.

China’s debt surpasses all previous emerging market lending bubbles. Over the last five years it has expanded nearly three times faster than the growth in US debt during the five-year period before the 2007/08 crisis. Yet China is still developing a regulatory framework, leaving independent institutions to manage the implications of the next potential crisis.

The failure of financial institutions during the last crisis was basically a result of risky business models fuelled by even more risky and inadequate capital structures.

Basel III enforced higher capital requirements and reporting standards. Systemically important financial institutions and the largest bank groups are subject to capital surcharges based on size, asset types and other rules. Banks have reduced proprietary trading, structured products, aggressive corporate lending and risky mortgages.

However, the changes in consumer and investor behaviour compared to 2008 represent one ill that regulatory reform cannot remedy.

This, and investors’ urgency in getting their capital back, affects how they will exit the three main asset classes that benefitted from QE (other than high-quality government fixed income): emerging markets, credit and equities.

On this basis, regulatory frameworks and systems could be severely challenged. Add into the mix how Dodd-Frank banned proprietary trading desks without understanding their impact on overall liquidity, and market and asset volatility will likely be sharper and last longer.

Building comprehensive and coordinated regulations represents a struggle to find a safe way forward in a new economic and financial world. Globalisation, fuelled by western neoliberal economics and American economic achievements through the 20th century, created a diverse global market. Free markets might sometimes be inefficient and periodically prone to crisis. As a result, regulations will need to originate from more than just the US and reflect other countries’ priorities.

The global economic recovery policymakers had hoped for after the 2008 crisis has not occurred. The world is still primarily driven by debt. This generates its own hazards that will challenge new financial regulations.

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