What is Bank Regulation? Why Do We Rely on Banking Regulation?
The fallout from the 2008 financial crisis was felt almost immediately. Governments around the developed world, having spent the previous decade ‘asleep at the wheel’, hurried furiously to introduce a flurry of new restrictions and regulations on banks. It did not take long for a ‘something must be done’ mentality to resonate not only in Britain, but in the United States and Europe too.
There is now some consensus across the political spectrum that the excesses of unfettered capitalism must be tamed. The argument for a minimalist ‘light touch’ to financial services is morally bankrupt. But six years on from the crisis and with bankers being paid record bonuses, has enough been done to ‘help to stop the rot’?
Crisis and Reform
Crises go hand in hand with reform. They hold a mirror up to society and challenge the wisdom of previously accepted norms. In this respect, 2007/8 was no different. Since the recession, financial services have become as much a political liability as they have an economic asset. Eager to engage with disenchanted voters, both the Obama and Cameron administrations have promised to mend their broken banks.
Yet, the appetite for a revolutionary overhaul of the financial system appears now to have faded into distant memory. As corporate banks dust themselves down and recapitalise their balance sheets, the temptation is simply to relapse into bad habits of the past.
Learning From the Past
Avoiding this temptation is no easy task. Banks are not like other businesses. Financial services contributed £65 billion in tax revenues to the Treasury in 2012/13, higher than any other sector of the economy. They also employ 1.1 million people in the UK alone. Fear that stifling regulations will undermine London’s competitiveness explains, in part, the lethargy with which the governments have been willing to countenance revolutionary reform.
Calls for financial prudence also come at a time when banks are being criticised heavily for their tight-fistedness and unwillingness to lend. Here, the conflict of interest is clear. Banks cannot both save for a rainy day and at the same time lend extensively to businesses and households. At the moment, the government seems to have trapped them between a proverbial rock and a hard place.
A comprehensively regulated and sustainable financial system must not be sacrificed in favour of political expediency and short-term economic growth.
A balance should to be maintained
The key will be balance. Banks must return to practicing intermediary functions and engage in more ‘boring banking’. However, they must also be free to pursue the commercial objective of profitability. Risks, where they are calculated and proportionate, are not incompatible with economic resilience and stability.
It is important too that banks are not led to believe they are somehow immune from insolvency or collapse. During the crisis, the problem of moral hazard became immediately apparent. If bankers know that the taxpayer will be waiting with a box of tissues and a blank cheque when things go wrong, the incentive to behave responsibly is fundamentally undermined.
Lesson from the 2008 Crisis
At the time, the then Governor of the Bank of England, Sir Mervyn King, was austere. In 2007, he warned that crucial to instilling discipline into financial markets is allowing failing banks to slide. He believed that financial prudence is grounded in an understanding that risky actions could have potentially damaging consequences.
However, large corporate banks were deemed ‘too big to fail’ when they got into trouble. The Bank of England acted as lender-of-last-resort, injecting liquidity into financial institutions by buying up the toxic assets and debt which banks were desperate to off-load. Meanwhile, the taxpayer got busy too – bailing out RBS and Northern Rock – which were both taken into public ownership.
The balance of liability and risk did not fall proportionally on the banks themselves. The Central Bank guaranteed all debt, including worthless toxic assets like sub-primes. This was a critical mistake. Indiscriminately buying up debt in this way threw all market discipline out of the window.
As Walter Bagehot presciently argued in 1854, in a crisis “Central Banks should lend freely to solvent depository institutions… they should, [however], do so against good collateral and at high enough interest rates to deter borrowers not in need.”
Risk needs to be distributed
Because banks had been allowed to become such large and complex organisations in the years preceding the crisis, they were able to exercise unprecedented leverage over the government. Now, proposals have been forwarded on both sides of the Atlantic to trim down, and even break up the very largest players in the market. Crucially, this will ensure that banks are responsible for themselves in the good years and the bad.
The banking sector cannot remain dominated by a small number of institutions, with disproportionate market share and jaw-dropping market capitalisations. Opening up financial services to competition from smaller players, such as Virgin Bank or Metro, would deter banks from exercising undue complacency and distribute risk between incumbents. It should also ensure that banks operate more in the interest of their consumers, for whose money they are ultimately responsible.
Heads we win, heads you lose.
There can be no ‘get out of jail free’ card for when things go wrong.
It is completely unacceptable that the private sector enjoys all the profit when the times are good and that the taxpayer is left to pick up the tab when it all goes wrong. This is not a game of ‘heads the banker wins, tails the taxpayer loses.’
Banks must look after themselves.
Since 2008, politicians, economists and journalists have spilt much ink exhaling the virtues of regulation. However, they have done so without due consideration of what this will actually mean in practice. Ben Bernanke reflected on the crisis and argued that it “showed not that regulation and supervision are ineffective…but that the execution must be better and smarter.”
So how do we make regulation better and smarter?
The Central Bank should be located at the centre of any credible regulatory framework. The links between monetary policy, market confidence and financial discipline are inextricable. Following Gordon Brown’s controversial legislation in 1998, supervision of financial services was transferred from the Bank of England to an independent ‘Financial Services Authority’. This was a mistake. If the Central Bank is responsible for administering the medicine to treat the hang-over in a crisis, then should they not also have the right to ‘take away the punch bowl’ in the good times too?
In recent years there have been steps taken to reassert the sovereignty of the Central Bank. The dark clouds of 2008 challenged the efficacy of independent regulation. The rot has not just harmed the integrity of the banks- the ratings agencies too have emerged bearing the same scars of imprudence and irresponsibility.
Stricter norms for ratings agencies
A careless ‘free-for-all’ mentality towards issuing coveted AAA ratings on debt obligations in pre-crisis years distorted an already complicated relationship between lenders and borrowers. Prized assets -considered ‘ultra-safe’, like US government bonds- were rated in the same way as toxic waste like CDOs – now termed Chernobyl Debt Obligations. These uncollateralised obligations were hardly worth the paper they were printed on.
The alphabet soup of assets, securities and debt obligations, coupled with the poor judgement of ratings agencies, made measuring and distinguishing financial risk virtually impossible. It was estimated that in 2007 there were as many as 64,000 different financial products available rated as AAA.
The agencies themselves, Standard and Poor, Moody’s and Fitch are commissioned for their services by the issuers of debt: largely the banks. If an agency gains a reputation for issuing tough, realistic ratings, then banks shop around and look elsewhere. It’s like giving a child the choice between having their exam script marked by a teacher who only ever gives ‘A*’s and a teacher who examines harshly and fairly, handing out mainly ‘Cs’.
For the financial system, the results proved very serious indeed.
Smaller, smarter regulation
Yet regulation since the crisis has been worryingly heedless to this problem. There must be greater transparency both in terms of what bundled debt actually consists of, and indeed, the tools deployed by agencies to measure the quality and risk of that debt. The focus seems to be aimed more at addressing the causes building up to bad debts, rather than flagging it up when it does accumulate.
Recommendations by the Vickers Report
For instance, in the UK, the Vickers Report recommended ‘ring-fencing’ the more risky investment banking activities (termed ‘casino banking’ by sceptics) from more conventional retail operations such as offering mortgages. The hope is that separation will prevent commercial banks such as Barclays from taking their depositors’ savings and using them to play ‘fast and loose’ in high risk ventures, such as issuing securities on uncollateralised debt.
It should also reduce exposure, avoiding a domino effect in which shocks in one sector of the financial system destabilise other sectors. But regulation of this nature scratches the surface of the complex and more intractable problems which frustrate the smooth functioning of financial markets.
Without an out-right ban on merging investment and retail banking, critics fear that financial institutions will be able to exploit the permeability of boundaries between them. Banks are not anchored by the strait laces of morality; after all, ’rules are there to be broken.’ Proponents of Vickers have stressed their plans to ‘electrify’ the ring-fence- but how this will be done is still unclear.
The solutions must address the causes, not just the symptoms. In the UK, unlike on Wall Street, banks have not been engaged heavily in investment banking. HBOS and RBS failed through risky practices in assets considered ‘safe’, such as mortgages.
Wholesale conduct of banks must be thoroughly examined
Separation is not an end in itself. The wholesale conduct of the banks must be subject to more thorough cross-examination, in particular of how much money they lend, that is their liabilities, in relation to the size of their assets. This kind of scrutiny has been driven principally through the Basel Accords.
Regulators have taken steps to embed greater resilience into financial institutions, and encourage them to ‘fix their roof while the sun is shining.’ Basel III legislated for a gargantuan ten-fold increase in the reserve capital ratio banks must now hold – a liquidity ‘cushion’ as high as 8%. In theory, recapitalisation will ensure that institutions are better placed to weather the storm, and independently of government.
These reforms accompany a new ‘stress test’ which has been designed to prevent the repetition of frantic write-downs and auctioneering of assets as seen at the height of 2008. Banks should not have to resort to panic-tactics in the event of a crisis. Scenes in 2007 of anxious savers queuing outside Northern Rock are the hallmark of a bank which has become over-extended in financial markets.
Preventing over-exposure has been a key objective of post-crisis regulation.
It is not difficult to forget though, that at the heart of the crisis were the bankers themselves. They, along with MPs and journalists, have spent the last six years vying for the position of ‘public enemy number one.’ Yet public animosity comes at a time when record bonuses are being issued at HSBC, Barclays and other high street banks. Why are we rewarding failure?
The perception that it’s ‘one rule for them, another rule for everyone else’ has put pressure on politicians to do more to moderate the opulent bonus culture which pervades Wall Street and the City. However, taming the banks has proved difficult. National interests, as is so often the case, stall progress in co-ordinating more global solutions.
The Bonus Culture
Managers in the City have underlined the need to maintain competitiveness in dynamic global labour markets. They say that a cap on bonuses would drive talent abroad and damage incentives for financial innovation. This only re-enforces the point that any meaningful solutions to the problem must be reached through international cooperation.
Perhaps EU legislation has been most encouraging in this regard. Regulators have reformed not just the size of banker’s bonuses, but crucially the means by which they are paid. In 2010, it was proposed that a typical bonus packet should consist of just 20-30% in up-front payment. The remainder, meanwhile, should be withheld for 3-5 years. In the past, high-flyers could simply threaten to quit and command higher salaries and bonuses elsewhere. Under new rules, this kind of brass-neck would result in them sacrificing years’ worth of deferred bonuses.
It is not entirely clear whether this regulation will be sufficient to dispel the sort of short-termism and arbitrary risk mentality which pervaded the pre-crisis years. Critics argue that 3-5 years is still not long enough. If bonuses were withheld for a decade, or even until retirement, then there were would be a solid iron social contract between bankers and shareholders.
It is crucial too that pay is performance related. ‘Reward for failure’ encourages complacency and damages incentives. The system must encourage -and not just expect- financial prudence. Equally, bankers must fulfil their side of the bargain, behaving in the spirit of the law and not just hiding behind its letter.
Don’t hate the player, hate the game
But before joining the long line of angry people queuing to ‘bash the bankers’, it is worth recognising that a poorly designed regulatory framework has been as responsible for recklessness as the egotistical bankers themselves. Bankers are human beings, and as such, they act in self-interest. Naturally, they seek immediate financial rewards. The important step forward now will be to channel that energy into long-term strategy and financial innovation, rather than erratic risks in search of short term pay packets.
Governments share responsibility for the failures in 2008. Their derisory attempts to instil market discipline on financial institutions clearly failed. The ‘tick-box’ micro-prudence regulation of the pre-crisis years was unfit for purpose. Regulators must be more dynamic in order to respond to the fast-moving conditions of financial markets. If the circumstances change, then they must shift the goal posts to reflect those changes.
Regulation, and indeed the regulators, must be smarter. In some respects, this has meant taking a retrograde step to a ‘pre-regulation’ era. Gone are the unwieldy statutory bureaucracies governing markets. Instead, and underlying Vickers’ proposals, there is an advocacy to move away from Roman Law type regulation, which is prescriptive, that is ‘you can do anything that is allowed’; towards Common Law, where you can do anything that is not prohibited.
The hope is a compromise: between calculated risk and financial innovation.
But these measures are meaningless unless greater parity can be established between different countries and banks. Steps towards achieving more ‘global’ solutions, to what are global problems have been painfully slow. Only cross-border cooperation will contain the devastating ripple-effect witnessed across the world in 2008.
Global capital flows cannot simply be banned. The benefits of spreading risk and building resilience into international markets far outweigh any destabilising effects they may have in times of trouble. Nonetheless, the scale of financial globalisation now requires a correspondingly ambitious programme of reform and regulation.
This has not as yet been forthcoming. Basel III, for instance, is being implemented differently across countries. In the US, accounting rules have been far more stringent on big banks. But even within Europe, Britain, France and Germany have proposed different bank holding-company structures. An idiosyncratic and localised legal environment will encourage banks to move capital around in search of unregulated ‘havens’, or to just play on their home turf.
Sir Mervyn King, the former governor of the Bank of England, famously commented that “global banks are international in life but national in death.” The challenges of financial globalisation are plenty, but so too are the benefits of international cooperation. Overcoming national boundaries and securing more globalised regulation will provide stable foundations upon which to construct resilient financial service sectors in the UK, Europe and America.
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