Politicians miss the point on regulation

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A risk manager at a large European bank now being propped up by its government after losing billions explains how the bank’s executives used to think about regulation. One question, he recalls, used to dominate its dealmakers’ meetings with the bank’s own legal counsel: “Can we get away with this?” No one ever asked: “Should we be doing this?”

It is easy to pour scorn on Angela Merkel, Nicolas Sarkozy, Gordon Brown and the other European members of the G20 for portraying February’s Berlin meeting as achieving any significant progress towards building a new and resilient architecture for global financial market regulation.

If you could go back in time and put a regulatory framework in place that would have prevented the calamity now engulfing the world financial system, it still would not focus on hedge funds or offshore tax havens. In pursuing these targets, the European leaders risk appear to be pursuing their own narrow ideological preoccupations and national self-interests.

The implication seems to be that it was the unregulated that are responsible for the mess we are in and that they took advantage of gaps in global regulation where no rules applied. But this is simply wrong.

Rather, it was a colossal failure of judgment by executives at highly regulated banks that over-lent to poor quality credits, in many cases thinned down their capital and under-invested in the deposit-gathering and other funding and liquidity infrastructure needed to support this asset gathering.

These banks were all subject to national regulators responsible for systemic soundness and to governance designed to protect their own individual institutions. But boards failed to constrain them, shareholders positively encouraged them in their imprudent risk taking, while central banks and securities regulators were blinded by the complexity of the vehicular finance system. Governments failed to act, happy with their tax take from bank profits.

In the past, international capital standards for banks have been agreed and overhauled. But Basle I and Basle II became simply another level in the game of regulatory arbitrage for unscrupulous banks to play and, when the storm hit, proved to have been at best inadequate and ineffective, at worst contributors to the pro-cyclical incentives to reduce capital buffers and over-rely on ratings agencies. Whole businesses grew up around regulatory capital arbitrage. Regulators did nothing.

For all this, in the run-up to the London G20 summit in April the European leaders are right to keep up the call that all financial markets, products and participants be subject to appropriate oversight and regulation, without exception and regardless of country of domicile. At a time when injudicious lending by Swedish and Italian banks in Latvia might contribute to bringing that country down and banks in Austria with it, enhanced cross-border oversight of banking-system risk is obviously needed.

In Berlin the EU leaders, amid their self-serving waffle, also repeated some entirely appropriate – if rather obvious and unoriginal – suggestions, including that banks should build up their capital cushions during the good times. Mitigating pro-cyclicality in regulatory policy is a good idea. So are strengthening the resilience and transparency of the credit default swap market through the establishment of a central counterparty; encouraging accounting standards setters to make it harder for financial institutions to hide liabilities off the balance sheet; and reducing the damaging capacity of ratings agencies to grant false levels of comfort.

How will improved and better internationally coordinated financial market regulation work? It needs clear and strong institutional and personal leadership. It should probably rest in central banks, which have ingrained in their culture notions of protecting the system as a whole, whereas securities regulators are more inclined to chase swindlers. But neither group has emerged from this sorry episode with reputations for competence or moral authority enhanced. In the US, the Federal Reserve contributed to the credit boom through its monetary policy and has hardly covered itself in glory in dealing with the messy aftermath. Similarly, in Europe, the ECB is now unashamedly pitching for the key role in macro-prudential supervision.

And the key issue remains unspoken. Bankers bamboozled their regulators and put them to sleep by paying top dollar for the smartest traders and most convincing snake-oil salesmen. They captured regulators and rating agencies alike, training their staffs on what questions they should be asking them, even as the banks devised more toxic products, sold them to related parties and called it a profitable business.

Regulators must be able to hire the brightest, the best and the most experienced game players. Taxpayers will have to be convinced that high salaries for top quality individuals are more than justified if they prevent hugely costly bank rescues. Banks must pay a full share for these salaries: having capable regulatory authorities is an operating cost of keeping the banks in business.