Fixing financial industry regulation is easy, provided you have perfect market information and can expect a fundamental change in human nature, says the head of the Office of the Superintendent of Financial Institutions. Otherwise, regulators should be scaling back their ambitions, she says.

In a speech to the Asian Banker Summit in Beijing Tuesday, Superintendent of Financial Institutions Julie Dickson reviewed some of the efforts underway to improve banking supervision in the wake of the financial crisis. She also spelled out how hard it will be to eliminate the threat of future crises, despite recent lessons.

Dickson noted that there is a growing consensus that one step must be to strengthen the macroprudential orientation of regulation. “This means that you need to focus on the financial strength of individual institutions, as well as the system as a whole,” she explained.

There are a couple of ways to do this, by improving monitoring and by altering the capital adequacy regime to take account of these systemic risks.

Dickson said that she thinks additional monitoring, combined with financial stability being added to mandates of regulators and central bankers, will help. “It will cause everyone to spend more time assessing such risks. It means that financial stability will get focus and will require a weighing against other policy goals, such as home ownership. This did not really happen prior to the crisis,” she said.

However, she cautioned against overselling the effect of greater focus on financial stability. “Some seem to be selling macroprudential monitoring as the panacea of permanent financial stability, but I think this is an elusive goal,” she said.

For one, achieving such stability must overcome human nature, our failure to learn from mistakes, our ability to convince ourselves that this time is different, and, as Dickson noted, “because powerful incentives are at play.”

“Looking at incentives requires us to look at a lot more than just bankers’ compensation packages,” she added. “It requires us to go down some paths that might be quite sensitive; many of them involve the depth to which the financial sector has pervaded our culture.” This includes the links between the financial industry, government, academia, and society at large.

“So while every downturn produces lessons to be learned, the question remains how to, or whether it is even possible to, alter human nature and the strong influence of incentives,” she said.

Another popular reform idea is reducing procyclicality with dynamic capital requirements — that go up in good times, so that banks are forced to build up capital reserves when profits are strong; and down in weak times, allowing them to draw down these reserves.

The question is just how you determine when times are good, when they are bad, and when they are changing from one state to the other. “Linking bank capital to macroeconomic indicators is extremely challenging because we cannot accurately predict business cycles. Part of the challenge is on the upside (where economic forecasters often get it wrong), and part is on the downside (where economic forecasters often get it wrong). This is not because forecasters are not smart; it is because we cannot accurately predict the future,” Dickson noted. she also pointed out that there are also lots of false signals.

Adopting automatic capital requirement adjustments may be a good idea, but she noted, “This involves predicting business cycles with more precision than we have today, and today we have no track record to speak of.”

“It may be that the most promising avenues to explore are higher quality tier 1 capital; leverage ratios; loan-to-value ratios; through-the-cycle estimates under pillar 2; and loan loss provisioning,” she said, noting that these have all helped the Canadian banking system weather the market turmoil. Other weaknesses in regulation and supervision are now being dealt with too, she said.

“I am sure that work will continue on proposals to develop counter-cyclical capital buffers that are automatic and go up and down at the right times. At the end of the day, while it may be that something can be developed, I am not as hopeful as many are,” she said.

“All of this suggests to me that we may need to be more humble in our aspirations,” she concluded. “The real world is ever-changing, dynamic, and innovative, with no complete understanding on the part of macroeconomists and regulators of how the parts acting on their own will affect the system. We are in a system of action and reaction with constant but not always successful attempts at anticipation. So we set out a framework, the framework is based on experience and lessons learned. Financial institutions act within this framework, but then something happens and we react and try to improve, institutions react and the cycle begins again.”

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