Post-crisis developments in financial regulation have led to extensive expansion in the regulatory perimeter as well as the imposition of demanding standards for prudential regulation in conduct of business. In the face of the Covid-19 crisis, which has buffeted the corporate sector in terms of sharp decline in levels of consumption, the financial sector has experienced strong headwinds as a result of its intermediary nature. Financial asset prices suffer volatility and decline as corporate securities and bond prices reflect real economy concerns over corporate insolvencies and knock-on effects on investors and lenders.
We observe widespread financial regulation suspensions at this time, endeavouring to strike a balance between allowing financial markets to remain functional, and mitigating short-termist damage to financial actors. In calling for lenders to have forbearance for their borrowers and to take a much more generous interpretation of non-performing loans (EBA, 12 March 2020), it can be argued that neither banks nor borrowers should be penalised by an interpretation that operates in relatively more predictable times. However, the crisis also reveals which borrowers and lenders are relatively more adversely exposed. In terms of mortgages, firms are requested to provide a mortgage payment holiday for three months if customers indicate that they may experience payment difficulties (FCA, 20 March 2020). Such loans will continue to be treated as performing. However, requiring banks to provide blanket payment holidays irrespective of whether mortgage holders have been affected by Covid-19 can lead to moral hazard and liquidity shortages.
Further, the UK’s dramatic U-turn in relation to its targeted 2% counter-cyclical buffer, which has been slashed to 0%, relaxes regulatory control on bank lending (FPC, 11 March 2020). However, allowing banks to release more credit into the economy does not guarantee the quality of these bank assets. In parallel, flexibility has been granted in connection to regulatory reporting to the PRA (Bank of England, 20 March 2020).
Next, the imposition of a moratorium by the FCA between 21 March and 5 April on companies issuing preliminary financial statements ahead of their audited annual reports (FCA, 21 March 2020) seems contrary to theoretical premises for price-efficient markets. However, such moratorium may address the relief needs of companies already experiencing operational disruption and also counteract capital market volatility by not flooding the market with yet more price-sensitive information.
On the other hand, certain existing powers have been intensified, creating a ‘suspension’ of a different type—of normal expectations as to the application of such powers. Regulators may increase demands under the same regulatory framework, potentially upsetting market participants’ transactional expectations in relation to their strategies according to the existing rule boundaries. ESMA has lowered the threshold for the duty to notify a competent authority of any short position to 0.1% of corporates’ issued share capital (ESMA Decision, 16 March 2020) and has supported the decisions of several National Competent Authorities to ban short selling for relatively long periods of time.
In all cases these decisions are suspensions of financial regulation. It pits regulators’ purported achievement of ‘overall’ good against the expectations of regulated entities. Suspension can instinctively appear to be reasonable, proportionate and even efficient, as based on treating as temporary an externally buffeting phenomenon that does not intrinsically reflect market or policy positions.
Suspensions are nevertheless counter-institutional in nature. We need to question if such counter-institutionality is indeed (a) needed in order to achieve the ‘overall’ good which legal institutions, as a form of social contract, are perceived to achieve in normal times; and (b) justified by the perception that institutions are only temporarily rendered out of sync by an exogenous factor.
Hence, we argue that regulators should have a perspective of counter-institutionality in exercising emergency powers and making unprecedented policy decisions. There is a need to develop an institutionally-coherent approach to suspensions of regulatory expectations as defined in this post. This means that counter-institutionality should still be justified within the key tenets of existing institutions.
First, regulators should institute stress-testing in relation to their suite of hard and flexible powers so that they can visualise the extent of suspensions, their interaction with other regulatory tools or indeed introduce gap-filling regulation, under a range of forward-looking scenarios. The capital buffers regime, for example, has in-built flexibility although the liquidity ratios do not. As the Basel Committee envisages the possibility of banks drawing down buffers in extraordinary times, the effects of such relaxation need to be balanced against harder regulatory operations. As regulators constantly worry about stranded asset risk for financial institutions in light of climate change, this type of medium to long term forward-looking scenario planning should provide regulators with greater anticipatory capacity. Even if scenario modelling cannot anticipate crises such as the onset of Covid-19, it could still prove useful in generally modelling adverse scenarios including natural disasters, commodity shortage, and failure of private and public sector institutions.
Further, regulators should develop a framework for how counter-institutionality and the exercise of emergency powers should be carried out, in a manner consistent with reasonableness, proportionality and efficiency in relation to suspensions. These decisions tend to be quick and usually not publicly consulted upon. Therefore, an ex ante framework is important to attribute legitimacy in terms of transparency and democratic accountability.
Such framework should include:
- Clear identification of the exogenous and endogenous aspects of the crisis at hand to assess the risk that emergency powers cause moral hazard or unwarranted market distortions.
- Alignment with regulatory objectives including intelligent appraisal of objective trade-offs.
- A broader crisis management standing arrangement between financial regulators and the Treasury beyond the Banking Act 2009.
- A reasonable cost-benefit matrix even if only qualitative inputs and imprecisely modelled risk management tools are available. This is consistent with an approach recommended by Sunstein (Valuing Life: Humanising the Regulatory State, University of Chicago Press, 2014), which emphasises the need for rational interventions to provide balance against heuristics and biases in human decision making.
- To develop all suspensions with an exit strategy in mind.
- To have a reasonable timeframe for suspension review by the institutions participating in the standing crisis management arrangement.
The counter-institutional nature of regulatory suspensions entails potential cost, in terms of quick but ill-informed judgment on regulators’ part, unintended consequences upon the incentives of market actors and moral hazard. Developing an ex ante framework for institutionalising the operation of suspensions would be helpful towards mitigating tail effects of institutional dissonance. Further, having such a framework in place would prompt regulators to critically evaluate extant rules and regulations so that a dynamic learning process of regulatory strengths and weaknesses can become habitual.
Iris H-Y Chiu is Professor of Company Law and Financial Regulation at the UCL Faculty of Laws
Andreas Kokkinis is an Associate Professor at the University of Warwick School of Law
Andrea Miglionico is Lecturer in Banking and Finance Law at the University of Reading