Risk USA: Standardised regulation will cause systemic risk, warns senior UBS risk controller

Regulators' efforts to prevent another crisis are having the opposite effect

Regulators are bringing about systemic risk by imposing prescriptive regulation on banks, warns a senior risk practitioner at UBS.

Paul Shotton, deputy head of firm-wide risk control and methodology for the Swiss bank, warned the Risk USA conference in New York yesterday that while regulators are trying to achieve a more stable financial market, their efforts will in fact work against them in the end.

"Even though these prescriptions may make any individual bank better risk managed than it would have been without that detailed prescription, regulators are actually bringing about the very opposite of what they should desire, because applying more uniformity is causing banks to think alike, to act alike and to put on their positions in a much more similar way, and that alignment will give rise to greater systemic risk. The very thing the regulators should care about the most is the thing they are bringing about through their ever-greater prescription."

He told the conference that while it may seem like a paradox, the way to have sound regulation is actually for regulators to encourage more diversity, more diversification of regulation and not uniformity.

Stress tests are particularly dangerous, Shotton warned. "Standardised stress testing, in my opinion, is one of the very worst things regulators can do to bring about systemic risk," he told delegates. "I think fundamentally it comes about because regulators misunderstand the nature of markets."

Thinking of financial markets as a casino – betting on the fall of a card or a die – fundamentally misunderstands the nature of the markets

Shotton also challenged the description of investment banking as "casino capitalism" by Adair Turner, formerly chief executive of the UK Financial Services Authority.

"Thinking of financial markets as a casino – betting on the fall of a card or a die – fundamentally misunderstands the nature of the markets, because in all those markets, the result of how the card falls or which horse wins the race is completely independent of the action in the betting market. Even if you argue that the horse may be doped, for example, the actual outcome of the race in the end isn't directly influenced by the state of the betting market. The two things are independent of one another."

He pointed out that in the case of the financial markets, foreign exchange rates or the level that stock price reaches, for example, are solely determined by the actions of the actors in the markets. "The buying and selling actions of market participants and the volume of money they are putting behind their bet precisely determine the outcome of their event. And that's the reason why markets are fundamentally adaptive," he said.

Regulators seem to ignore the fact that markets adapt to changes and impositions on them, Shotton told delegates. "They seem to think the markets will stay static, and so the more rules, the more they try to box things in, the more prescriptive they make the rules, somehow they can prevent the next crisis from occurring. In my opinion, all they will bring about is a much worse crisis in the future through the result of greater standardisation."