Can regulation drive innovation in finance? Lessons from green mortgage products

Benjamin Guin, Mahmoud Fatouh and Haluk Unal

Regulation has been asserted to be a brake on innovation. Prudential rules impose capital, liquidity and disclosure requirements, as well as stress tests, to strengthen resilience and manage risks – though some view them as potentially limiting financial innovation. Yet recent evidence from the UK mortgage market suggests the opposite: regulation can sometimes catalyse innovation, not suppress it.

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A simple model of the effects of entity and activity constraints on alternative investment funds

Leo Fernandes, Harkeerit Kalsi, Nicholas Vause, Matthew Downer, Sarah Ek and Sebastian Maxted

Hedge funds and other alternative investment funds (AIFs) often take positions in financial markets that significantly exceed their investors’ capital by using debt or derivatives. However, such ‘leverage’ can pose risks to financial stability. Regulators seeking to reduce these risks may consider applying constraints to the fund entities or the activities in which they engage. In this post, we use a simple portfolio choice model to examine the effects of the two approaches on fund investments. Under the entity-based approach, we find that fund managers substitute from lower-risk to higher-risk investments, whereas an activity-based approach can avoid this unintended reallocation by targeting specific investments.

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The Basel regulatory framework: evolution of its textual complexity

James Brookes, Matthew Everitt and Quynh-Anh Vo

The Basel III framework put in place in the aftermath of the Global Financial Crisis 2007–08 consists of a range of regulatory standards, each addressing a specific source of financial instability. Its implementation has however led to active discussion about whether the complexity of financial regulations has materially increased. This blog post presents insights from an analysis on the evolution of textual complexity of the Basel framework.

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Negotiating nationalisation

Austen Saunders

1 March 2021 was the 75th anniversary of the Bank of England’s nationalisation. While its stock formerly passed into public ownership in 1946, Lord Catto (the Governor) and Hugh Dalton (the Chancellor of the Exchequer) had negotiated the terms of the Bank’s nationalisation the summer before. During these negotiations Catto lobbied for the Bank not to be given more powers to regulate banks. Why? The answer hinges on how the Bank understood its role. And it helps explain why, as David Kynaston sees it, the Bank and the government ‘missed a historic opportunity’ to comprehensively redefine the Bank’s responsibilities.

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The language of rules: textual complexity in banking reforms

Zahid Amadxarif, James Brookes, Nicola Garbarino, Rajan Patel and Eryk Walczak

The banking reforms that followed the financial crisis of 2007-08 led to an increase in UK banking regulation from almost 400,000 to over 720,000 words. Did the increase in the length of regulation lead to an increase in complexity?

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Bitesize: The rise and fall of interest only mortgages

Sachin Galaiya

The interest-only product has undergone tremendous evolution, from its mass-market glory days in the run-up to the crisis, to its rebirth as a niche product. However, since reaching a low-point in 2016, the interest-only market is starting to show signs of life again as lenders re-enter the market.

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Will Pay Clawback Tame Damaging Risk-Taking In The City?

Misa Tanaka and John Thanassoulis

In the 2007-8 global financial crisis, a number of banks were bailed out by taxpayers while their most senior employees were paid extraordinary bonuses up to that point (E.g. here, here and here). The resulting public outcry led to new regulations allowing clawback of bonuses earned on the back of decisions that subsequently damage their banks and the wider economy. But will these rules work? Our theoretical research shows that sophisticated banks can game clawback regulations by altering pay contracts so as to incentivise bankers to take risks that benefit shareholders but that are excessive for society. The entire pay package matters, and so, understanding how it shapes risk-taking incentives is as important as monitoring compliance with clawback rules.

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Insurance companies: amplifiers or the white knights of financial markets?

Graeme Douglas, Nicholas Vause and Joseph Noss

Risky asset prices plummeted following the collapse of Lehman Brothers in 2008. Whilst driven partly by deteriorations in fundamental news, these falls were amplified by ‘flighty’ investors that sold at the first signs of trouble. Conventional wisdom dictates that life insurers, with their long-term investment horizons, are better placed than most to ‘lean against the wind’ by looking through short-term fluctuations in asset prices. They could thereby stabilise prices when others are selling. But the structure of regulations can greatly influence insurers’ investment incentives. Using our model of insurers’ asset allocations, we find that new ‘Solvency II’ regulations reduce UK life insurers’ willingness to act as the white knights of financial markets, particularly in the face of falling interest rates.

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The Dog and the Boomerang: in defence of regulatory complexity

Joseph Noss and David Murphy

For some years, financial regulations have been becoming more complex. This has led some prominent commentators, regulators and regulatory bodies, to set out the case for simplicity, including Adrian Blundell–Wignall, Andy Haldane, Basel Committee and Dan Tarullo. In his contribution, Haldane illustrates how simple rules can achieve complex tasks: by simply adjusting its speed to keep its angle of gaze fixed, a dog can manage the complex task of catching a Frisbee. In this post, however, we argue that some financial risks are hard to catch with simple rules – they are more like a boomerang’s flight path than that of a Frisbee. Complex rules can sometimes do a better job at catching risk; and simple rules can be less prudent.

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Guest post: Why regulators should focus on bankers’ incentives

Charles Goodhart

Last autumn, Charles Goodhart gave a special lecture at the Bank. In this guest post he argues that regulators should focus more on the incentives of individual decision makers.

The incentive for those in any institution is to justify and extol the virtues of the decisions that they have taken. Criticisms of current regulatory measures are more likely to come from outsiders, perhaps especially from academics, (with tenure), who can play the fool to the regulatory king. I offer some thoughts here from that perspective. I contend that the regulatory failures that led to the crisis and the shortcomings of regulation since are largely derived from a failure to identify the persons responsible for bad decisions. Banks cannot take decisions, exhibit behaviour, or have feelings – but individuals can. The solution lies in reforming the governance set-up and realigning incentives faced by banks’ management.

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