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Investment risk regulation impacts

Investment risk regulation –
An opinion: Investment Risk should not be over regulated

In times of extreme volatility and the failing confidence of investors in the capital markets, governments can be tempted to introduce investment risk regulation to bolster the financial system to remove (or at least reduce) market risk.

The Risks in over regulating Risk in financial markets …

The author, Lloyd Blankfein, as Chief Executive at Goldman Sachs, New York: and after setting out a number of lessons to be learned by participants in the merchant bank and financial services industries (and stating that company’s executives’ decision to not receive their 2008 year bonus for reasons including some of those lessons), went on to say –

“For policymakers and regulators, it should be clear that self-regulation has its limits. We rationalised and justified the downward pricing of risk on the grounds that it was different. We did so because our self-interest in preserving and expanding our market share, as competitors, sometimes blinds us – especially when exuberance is at its peak. At the very least, fixing a system-wide problem, elevating standards or driving the industry to a collective response requires effective central regulation and the convening power of regulators.

Capital, credit and underwriting standards should be subject to more “dynamic regulation”. Regulators should consider the regulatory inputs and outputs needed to ensure a regime that is nimble and strong enough to identify and appropriately constrain market excesses, particularly in a sustained period of economic growth. Just as the Federal Reserve adjusts interest rates up to curb economic frenzy, various benchmarks and ratios could be appropriately calibrated. To increase overall transparency and help ensure that book value really means book value, regulators should require that all assets across financial institutions be similarly valued. Fair value accounting gives investors more clarity with respect to balance sheet risk.

The level of global supervisory co-ordination and communication should reflect the global inter-connectedness of markets. Regulators should implement more robust information sharing and harmonised disclosure, coupled with a more systemic, effective reporting regime for institutions and main market participants. Without this, regulators will lack essential tools to help them understand levels of systemic vulnerability in the banking sector and in financial markets more broadly.

In this vein, all pools of capital that depend on the smooth functioning of the financial system and are large enough to be a burden on it in a crisis should be subject to some degree of regulation.

After the shocks of recent months and the associated economic pain, there is a natural and appropriate desire for wholesale reform of our regulatory regime. We should resist a response, however, that is solely designed around protecting us from the 100-year storm. Taking risk completely out of the system will be at the cost of economic growth. Similarly, if we abandon, as opposed to regulate, market mechanisms created decades ago, such as securitisation and derivatives, we may end up constraining access to capital and the efficient hedging and distribution of risk, when we ultimately do come through this crisis.”

[Extracted from an article published in The Financial Times on 8 February 2009. To read the complete article, go to this link on our website.]

Investment risk regulation timeliness

Investment risk regulation needs to be nimble – not an attribute usually assigned to government action. There is no disputing that the GFC was a very significant event in financial markets – and in economies generally. Unfortunately, even though many were commenting on the fact that the unsustainable growth of the 2004 through 2007 years “couldn’t last”, none of us – professionals or otherwise – had the ability to avoid the timing in taking control of the potential downside: and we hazard a guess that no one had any concept that the fall would be so swift, so deep, nor so prolonged. Legislative action tends to stay in force (I almost used the word, effective) for lengthy periods of time: introducing it without appropriate sunset clauses, could lead to market distortions when the events giving rise to it, are reversed – or significantly changed.

Investment risk benefits

The encouraging ‘fact’ is that over the extended period between WWII and late-2007, Australian equities returned around 12% p.a. on a 10-year rolling basis. Following the GFC, these same equities achieved significant growth for about five years. The lower returns for longer environment that has settled into markets since the activity of Central Banks around the world, flooded investment markets with money under their quantitative easing programs, will probably result in these returns over ten-year rolling periods, falling to high single digits.

The inevitable outcome, is that with modest regulation, investment markets will do their job of providing capital for growth and development of industry, infrastructure and services – and provide a reasonable return to those who risk their capital to finance these assets and undertakings.

Investment risk applied

In any event, careful determination of an appropriate strategy remains the most effective way to deal with long-term investing. The experienced advisers at Continuum Financial Planners Pty Ltd are available to work with you to explore your investor risk profile, identify your financial goals and objectives and to provide you with well-reasoned investment strategies targeting those goals. You can arrange a meeting with one of our team by calling our office (on 07-34213456), or by completing the Contact Us form on our website – and in response you will receive prompt and courteous attention.

[This post was originally published in March 2009: it has been refreshed/ updated occasionally, most recently in March 2017]

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