Bank regulation needs straightening out

By Peter Thal Larsen

Published: March 30 2009 20:16 | Last updated: March 30 2009 20:16

New elements in Regulation

These include forcing banks to set aside more capital during good times, increasing scrutiny of ratings agencies, broadening the regulatory umbrella to capture all institutions that pose a potential risk to financial stability, setting up central clearing and settlement for over-the-counter derivatives and overhauling banks’ bonus policies. The authors also agree that regulators and central banks must in future be explicitly charged with spotting problems as they build up in the system and be given the power to prick future bubbles before they grow too large.

ELEMENTS OF A NEW ORDER

Who does what right now? ●Global bodies, such as the Basel Committee on Banking Supervision, agree policy. ●Decisions are adopted by local supervisors. In some cases, such as in the European Union, these are enshrined in law. ●National regulators ensure implementation of rules and scrutinise local institutions. ●In Europe, a system of committees seeks to ensure a consistent approach.

What is being proposed? ●Increased capital reserves for banks and a requirement they build up reserves during boom periods. ●Consistent regulation of any institution capable of disrupting the stability of the system. ●A crackdown on ratings agencies. ●Central clearing and settlement for over-the-counter derivatives. ●An overhaul of bonus systems to encourage long-term thinking, with clawbacks of bonuses based on profits that turn into losses. ● A system of macro-prudential regulation to prick future bubbles.

Who will do what in the future? ●Beefed-up international bodies, such as the Financial Stability Forum, can oversee global regulation. Membership of the FSF and Basel Committee will include developing nations. ● Pan-European regulators will oversee consistent regulation and resolve disputes. ●The US patchwork will end, with regulatory power consolidated probably in the Fed.

What is still to be resolved? ●A cross-border system for allocating the costs of bailing out failing banks. ●A resolution regime, consistent across borders, that allows even large institutions to be closed down in an orderly way. ●Whether investment banking should be separated from commercial banking.

The new approach is based on an acknowledgement that the market cannot be counted on to limit excess. “The financial crisis has challenged the intellectual assumptions on which previous regulatory approaches were largely built, and in particular the theory of rational and self-correcting markets,” Lord Turner declared this month. “Much financial innovation has proved of little value, and market discipline of individual bank strategies has often proved ineffective.”

A particular source of concern is those institutions that are deemed too large to be allowed to fail. One option is to submit them to even more intrusive regulation to minimise the risk of a collapse. “Any firm whose failure would pose a systemic risk must receive especially close supervisory oversight of its risk-taking, risk management and financial condition, and be held to high capital and liquidity standards,” Ben Bernanke, Fed chairman, said in a speech this month.

An alternative is to force banks to become smaller by preventing them from combining different business lines under one roof. This approach recalls Glass-Steagall, the Depression-era US law that separated investment banking from commercial banking and defined the shape of US financial services until it was repealed in the late 1990s.

Mervyn King, governor of the Bank of England, recently called for a “public and informed debate” on the issue. Others are less convinced it is possible to draw a line between activities. What is more, while laws remain static, institutions evolve. Ten years ago, Bear Stearns could probably have failed without dragging down the system. But although it had not crossed over into retail banking, Bear’s position as a counterparty in derivatives meant it posed a threat when it got into trouble a year ago, forcing the Fed to organise a bail-out. “Is there such a thing as a non-regulated part of the financial sector that you can afford to ignore?” asks the chief executive of a large US bank.

Mr Bernanke is pushing to broaden the rules, which currently apply only to banks regulated by the Federal Deposit Insurance Corporation, to include all significant institutions. This would also help prevent banks from acting recklessly in the knowledge they will be saved, he argued this month, saying: “Improved resolution procedures...would help reduce the too-big-to-fail problem by narrowing the range of circumstances that might be expected to prompt government intervention to keep the firm operating.”

What is the outlook for banking?

Regulators have taken some sensible steps. When scrutinising global banks such as HSBC, they have organised “colleges” of supervisors, with representatives from each country where the bank has a significant presence. Mr de Larosière also proposes creating a pan-European regulator called the European System of Financial Supervision, which could enforce common standards among regulators. To the surprise of many, Lord Turner endorsed the idea.

Yet any discussion of greater co-operation between regulators is incomplete without some agreement on who should pay the bill. In the current crisis, taxpayers in the bank’s home country have tended to bear the costs of a bail-out. As Lord Turner says Mr King once quipped: “Global banks are global in life and national in death.”

This is far from ideal. As the meltdown in Iceland last autumn showed, an economy can be overwhelmed by its banking system. Equally, the few cross-border bail-outs attempted so far have ended in disaster. A senior European financial executive points out that the board of Mr de Larosière’s proposed ESFS would have 27 members: hardly a grouping capable of swift action. “There is a real risk we may not have a European financial system unless this is addressed,” he says.

DEVELOPING WORLD

New faces on the way to Basel

The next time banking regulators gather in the Swiss city of Basel to discuss the finer points of capital regulation, they will need a bigger room. The Basel Committee on Banking Supervision, which sets global standards for the banking industry, is adding seven members.

The inclusion of Australia, Brazil, China, India, South Korea, Mexico and Russia expands the committee’s membership to 20. It also gives a more global mix to a grouping that, with the exception of Japan, previously consisted only of European and North American members.

These moves reflect a recognition that the problems of the global financial system cannot be solved just by the west. The Group of Seven club of rich nations has been displaced as the main forum for international summitry by the G20. Given the increased economic clout wielded by countries such as China and Brazil, this seems only logical. Not long ago, emerging economies would look to the US and Europe to lead the way in drawing up banking rules. But the western approach to financial regulation has been discredited by the crisis.

Reaching consensus may be even harder in the future. “You have got new players coming on the scene, and that means the arrangements that are currently around get put under pressure,” says Michael Foot, a former Bank of England and Financial Services Authority official who is now UK chairman of Promontory Financial Group.

What happens if politicians fail to agree? The most likely outcome is that decades of global financial integration begin to unravel. Under pressure from governments eager to see taxpayers’ money spent at home, banks are already withdrawing capital from areas such as central and eastern Europe.

National regulators are also putting up greater barriers. The FSA has angered foreign banks by proposing regulations that could require them to hold a greater proportion of liquid assets in their London subsidiaries. The system whereby any European Union bank can offer its services in another country without opening a separate subsidiary – a key part of the single market – is also under threat.

If pursued to their logical conclusion, these trends could make it harder for financial institutions to operate across borders. If banking again became a largely national industry, the size of financial institutions would be limited by the size of the economies in which they are based. The idea that countries can develop a competitive advantage in financial services – a main driver for the expansion of the City of London in recent decades – would be dismissed. Competition would be reduced and the cost of debt for companies and consumers would be likely to rise.

When the G20 delegates troop into the Excel centre on Thursday, they will have to make a difficult choice. As Dirk Schoenmaker of the Duisenberg School of Finance in Amsterdam points out: “A stable financial system, an integrated financial system and national financial autonomy are incompatible.” One of the three must be sacrificed.

Given the damage caused by the crisis, stability must come first. But this can be achieved on an international basis only if politicians – and the taxpayers who elect them – are willing to cede some control over the purse strings.

Read the text about overhauling financial regulation in Europe and the US and distinguish advantages and disadvantages of such overhaul from the viewpoint of banking industry executives