Can bankers be their own cops?

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In the old days, regulators set the rules and bankers followed them. Now, the Group of Thirty wants to create voluntary standards for global risk management. Some people applaud this experiment. But bankers who Oppose it have been biting their tongues. James Smalhout reports.

Voluntary self-regulation on a global scale may be the answer to controlling systemic risk to the financial system, according to some industry participants. For others, such an approach could accentuate the very problems it is trying to solve.

"It's a noble effort," says banking consultant Bert Ely of the Group of Thirty report Global Institutions, National Supervision and Systemic Risk, "but the approach has fatal flaws. The G30 wants to marry industry self-regulation with government supervision in a manner that is unworkable.

"The operative principle will be that if institutions don't do a good job of policing themselves, the standing committee will kick them out of the club," says Ely. "That may be fine for those who remain, but those who get kicked out will still be in business." Ely expects some would become industry renegades, causing the type of problems that lead to government supervision in the first place.

Many institutions have made great strides in developing their risk management systems in the past few years but Brian Quinn, a former head of supervision at the Bank of England and a member of the G30 study team, worries that: "The people who responded to our survey expressed confidence in their own risk management and their main counterparties, but that confidence was not based on any very detailed knowledge of what their counterparties were actually doing and how they manage themselves. To a certain extent, it was an act of faith."

Tom Russo, a managing director at Lehman Brothers, thinks self-regulation on a global scale is the answer. Russo tried this approach domestically as a member of the Derivatives Policy Group, made up of America's six largest investment banks. High US government officials actively supported them. Two years ago, the DPG produced a "voluntary" framework for managing risks from over-the-counter derivatives (those not traded on a regulated exchange).

Gerald Corrigan, formerly president of the Federal Reserve Bank of New York, is candid. "There are those who have construed the G30 report as a major thrust in the direction of self-regulation per se. I don't see it that way. I think it's complementary to official regulation and can make it work more efficiently and more effectively. It would be a mistake to conclude that this in any way weakens or undermines the role of supervisory authorities. As a practical matter, there is absolutely no enforcement power whatsoever vested with the standing committee. That's why it's wrong to think of this as self-regulation."

Marshall Carter, president and CEO of State Street Bank & Trust in Boston, believes that the next step should involve the G7 or the G10 finance ministers and their deputies. This worked for the G30 in the wake of its highly successful project on clearing and settlement several years ago. Carter is a strong supporter the G30, but does not expect to serve on the proposed standing committee.

But some observers think that the official community would never need to become directly involved. They predict that few institutions would hold out if the 20, 30 or 50 major participants agreed to operate according to the standards and did so. But they assume, of course, that one of the standards would prohibit transactions with counterparties who were not in compliance.

So the pressure on individual institutions would be enormous either to observe the standards or to find operating procedures that would persuade the rest of the market that they were comparably safe. Any institution operating outside the standard would therefore have a reduced capacity to create a systemic risk, or so the argument goes.

But an influential US Congress staff member objects: "First, you're giving a small group from the private sector governmental power. Behind governmental power in the end is the use of force. However select and representative this group might be, nobody elected them to anything. This also allows government to increase regulation while pretending that it's private business regulating itself. Both of these aspects are abusive because they avoid the kind of public scrutiny that representative government requires."

And most American legislators would no doubt agree that it's very beneficial to develop international rules by consulting as much as possible with the people who must live with them. But governments start getting into trouble when they institutionalize that consultation process and give a public role to the private sector. At least one well-placed staffer believes that regulators should consult explicitly with the private sector on their own behalf, using their own staffs, at their own public hearings.

Congress had similar concerns about the Derivative Policy Group. Its recommendations are said to be voluntary, but institutions that don't follow them will be looked on very unfavourably by credit-rating agencies, investors and others. So how voluntary are they in practice?

The threat goes from the bottom up and the top down. Industry self-regulation can be used by the private sector to "capture" its regulators. Such mechanisms allow favoured businesses to increase their protected position in the marketplace. Government, meanwhile, can use industry self-regulation as a means to regulate business "implicitly".

Robert Litan, director of economic studies at the Brookings Institution and a former anti-trust official in the Clinton administration, sees the potential for anti-competitive behaviour in these terms: "If you have a body that starts to decide who's good and who's bad, then there's a question of due process. You could have an anti-trust complaint being brought by somebody who said that they got screwed because there was a kangaroo court set up to judge them. I don't think that's what the G30 is recommending. What I do see is a first step where banks get together to agree on the best way to prevent rogue traders from ripping them off, to agree on some of the best ways to model risk and so forth. Then, they can hand it over to the regulators who can figure out whether people are complying."

The basic idea in the G30 report, according to Bert Ely, "is to look to the accounting firms to save the day. The supervisors would, in effect, free ride off the principles and best practices developed by the standing committee and then apply them to everybody, including those who are reluctant to participate and find some way to evade. That puts the monkey on the back of the accounting firms."

Ely wonders whether the Big Six accounting firms would be willing to take on this job for an affordable price. They paid out $2 billion or more during the past 10 years as a result of bank and S&L failures in the US. So, Ely reminds us that: "The Big Six are becoming increasingly picky about whom they audit, as well they should."

Professor Charles Calomiris of Columbia University has other doubts about the external audits: "Who's doing it and how much money do they lose if it turns out that they're wrong? How can anyone who lived through the BCCI episode think that we can rely on accounting firms? It's important to align incentives by having people who evaluate risk putting their own money on the line at least in part. The legal risk of being sued for having an incorrect opinion is not going to be sufficient. These are very complicated and subtle transactions. It's not enough to be able to detect fraud or incorrect information. Many banks have different models - which one should the accounting firm accept? Are you going to hold an accounting firm responsible if its measure of market risk turns out to have been wrong? Should they be sued for having been fraudulent? Of course not."

Not surprisingly, the view from Price Waterhouse is very different. Says partner Robert Sullivan: "I don't think it's a question of the accounting firms not having enough money or skin in the game. I think we would."

Instead, Sullivan wonders whether it would be robust enough to meet the G30's expectations or a "check the box" type of activity. "The Derivatives Policy Group developed a similar framework a few years ago," he notes. "They had the accounting firms do a review of internal controls related to risk management. It was fairly limited and there was an understandable concern with controlling costs. Similar processes have put a lot of pressure on external auditors to say a lot and do a little."

Shyam Venkat, another Price Waterhouse partner, cautions: "This can create expectations that none of these firms is ever likely to sustain a loss. But trading losses will continue. The issue in a Barings-type situation involves not just systems for risk management - although their systems were probably poor also - but the infrastructure for making sure that they process and properly report on the trading activity so that it can be assimilated into the institution's risk management framework. Culture, training and individual personalities are major parts of this activity. The focus for the external auditors ought to be the adequacy of risk management skills, processes and systems rather than providing any sort of certification that losses would not occur."

In this setting, Hal Scott, Nomura professor of international financial institutions at the Harvard Law School, hails the G30 report as "a very important contribution to thinking about how we can improve the functioning of the international financial system without creating new bureaucratic standards and empowering unnecessarily new or even old international organizations".

Scott points out that the focus of the G30 report is private, unlike Morris Goldstein's recent "international banking standard" or even the G10 initiative to promote financial stability in emerging market economies. Scott praises the G30 for "not trying to create international rules. It's trying to create a framework. I sense that the framework will be a performance-oriented standard. It will probably say that firms must have a system that can do X, Y and Z, while acknowledging that different firms can do it differently. The thrust of this is self-regulatory. It calls for the key private firms to get together and create an agreed upon framework for controlling risk."

Goldstein is more cautious. "This is really the view from Mount Olympus," he says. "It's not yet the nitty gritty that we need. The trick is to actually write down the guidelines. The G30 calls for a standing committee to do it. We're not going to know for another year or so whether we've really got something that's useful or whether we've got pie in the sky. At the same time, the whole point of regulation is that there are differences in private and social costs."

Not everybody is so receptive. As Anna Schwartz of the National Bureau of Economic Research sees it: "If the problem is that a shock could threaten a major financial institution and then cascade through the international financial system threatening other major institutions and the financial infrastructure of the international system itself, this report just doesn't develop that theme."

Benn Steil, director of the international economics programme at the Royal Institute of International Affairs in London, faults the report for overlooking the role of government in the problems it cited in Japan, Finland, France, the US and Mexico.

"The standards will be used to legitimize international bail-outs," complains Allan Meltzer, a professor at Carnegie-Mellon University. "That is bound to encourage even worse behaviour on the part of countries prone to get into trouble. Central banks are fully capable of containing the effects of bank failures by providing liquidity to the system. These crises wouldn't happen if governments and central banks pursued correct policies. But they have certainly kept international bureaucrats busy with make-work projects."

Yet the financial system today has never been in better shape to withstand shocks from the occasional failure of poorly managed institutions. With very few exceptions, major national banks and internationally active financial institutions are in stronger financial condition than they were a decade ago. There's also much more liquidity in the markets these days and a much more diverse group of players. One thing that many observers find encouraging about today's global financial system is that when concerns arise about the creditworthiness of a country or a company they can be reflected immediately in the price of debt or equity. In the 1980s, that simply wasn't the case. And derivatives in general are expressly designed to shift risk from one participant to another. So, there now are more strands in the safety net.

The system is more competitive and margins are thinner. But innovation and liberalization present a trade-off. On the one hand, they provide a more flexible and responsive financial system. But, by cutting the margins, they also leave less room for mistakes should an institution fail to control its operating risks. As one savvy observer notes: "We're in an area where I feel less concerned than before that there would be an accident. But I feel concerned that if there was an accident it could very quickly become a large pile-up with $5 trillion a day moving through the payments system."

Charles Dallara, managing director of the Institute of International Finance, says: "We need a supervisory structure that is built on globalization and the way in which risks are managed by market participants today. The G30 report is valuable because it points out some of the problems in today's supervisory regimes."

Dallara is convinced that "regulators are so bound up in their jurisdictional rigidities and in the reality of their national political circumstances that they wouldn't be able to develop new supervisory regimes which are coherent and consistent with modern realities without some leadership from the marketplace".

In the absence of this, Dallara fears legal initiatives in countries around the world which are neither flexible enough nor forward-looking enough to capture where the marketplace is going.

IIF produced its own report early this year on the supervision of financial conglomerates. It aims in part at reducing the high cost of dealing with different regulators around the world. "Regulators are often tempted to require more and more somewhat overlapping, somewhat inconsistent reports in somewhat different formats," Dallara complains.

Comments Brian Quinn: "The proposal for a lead coordinator [among bank supervisors] was one of the trickiest subjects that the study group was asked to address. Different countries have different degrees of enthusiasm for it. The attraction is greater in Europe than it is in the US, for example. You're talking about turf here. So it won't be easy."

Nor is it clear what the umbrella regulator would do. At Brookings, Bob Litan illustrates the problem: "It would be one thing for them to send their own examiners out. Let's say Citibank is involved in 80 countries. In theory, the umbrella regulator could send armies of people all over the world to look at the Citibank subs and then come back and report at home. That's a totally impractical suggestion and one that almost certainly would raise hackles in host countries. So, the fallback would be for the umbrella regulator to rely on reports from the host countries. It's not clear how much value the proposal adds, since this is basically what happens now."

As a member of the study group, Quinn responds: "There's got to be a degree of sacrifice among individual authorities in agreeing that someone else should have an overview of their institution. So, the report is fairly modest in its aim: a co-ordinating role in the first stage, not any sort of active, hands-on role. The value-added comes from the overview."

But that may not fly politically. As the congressional staff member sees it: "I don't know that there's a need for on-going meetings of bank supervisors from different countries. Right now, we have something of an ad hoc process and I think it's better to use that flexibility. The US generally takes the lead because we're the biggest player. And we probably should as long as that remains the case."

At the end of the day, opinion is very divided about the impact of the G30 proposals on the offshore financial centres. One senior official takes the view that offshore centres will be marginalized unless they ensure that institutions operating there conform with best practice. At the moment, institutions don't lose that much protection by dealing offshore because there is no standard for best practice and they may not know much about the vulnerability of their counterparties. People might as well deal with Citibank in Montserrat, the Cayman Islands or Bahrain as in New York.

All that can be said with confidence about lesser institutions is that they meet the standards to the satisfaction of the local authorities, even though those standards may be very different in different jurisdictions. Something like the G30 approach could make it easier to judge the quality of regulation in offshore centres. It could also force institutions operating there to bring their game up to the standard of the major centres or lose business.

A prominent banker meanwhile thinks that the recommendations will actually be helpful to those that won't play along. The G30 wants the framework to apply to everybody, but admits that the only firms it can really influence are those already regulated. So it falls back on commercial and investment banks as the place to start. He fears that adding more burdens to what they do by trying to prescribe a single set of risk management approaches will ossify and rigidify the structures they use - if it actually happens. The framework would make it harder for them to do business, drive up their costs and lower returns. So the hedge funds will just get bigger.

To some extent, the debate is being driven by a generational divide. As one banker puts it: "There are a bunch of senior guys in the business, like the greybeards whose names are on this report, who are more comfortable if everybody is regulated or at least gives the illusion of being regulated. One could view the Derivatives Policy Group as an attempt by those firms whose affiliates are not regulated to create the illusion of regulation by writing down a set of 'voluntary' principles and having the SEC in the room when they did it.

"There are other guys who think that not everybody needs to be regulated. They know there's risk and are comfortable with the inevitability of taking losses. If we didn't have those events, then every investment would be no more risky than US government bonds. That's not the way the world is supposed to work. So, we live with risk and manage it. Studies like this should look at the whole portfolio of activity rather than picking out particular events. There's a sense in which the G30 report responds to anecdote, rather than to a global survey."

But Paul Volcker doesn't give such complaints much weight. "Some people think that any regulation is bad," he says. 'I don't think that is a common view among most seasoned market observers. Adam Smith himself made this point. There are questions of free riding. There are questions of group behaviour that in some cases can become self-destructive. That's why we have lenders of last resort, central banks and banking regulations. I have noted a distinct correlation between those who take this view most avidly and those who come to the government for help when they get in trouble."

Volcker goes on to say: "Both intellectual analysis and practical observation of the repeated debt crises in recent years suggest that there is such a thing as systemic risk. Yet, people deny it even when they have Thailand right on their front doorstep."

Volcker remains ever vigilant. "What I would like to see as chairman of the G30," he says, "is some assurance that what comes out is a balanced view that reflects the dangers of excessive and unnecessary regulation and at the same time does not ignore the legitimate need that might exist for cooperation. I would like to see an intelligent reflection of the risks and opportunities."

Let's hope that they deliver nothing less.