The international system of bank regulation, epitomised by the Basle II process and light-touch principles-based regulation of Britain’s Financial Services Authority has comprehensively failed.
In too many instances, light-touch principles-based regulation with an emphasis on banks’ internal risk controls turned out to be no effective regulation at all.
Former Fed Chairman Alan Greenspan was the most prominent proponent of this approach, which relied on the profit-maximising self interest of financial institutions to limit risk-taking to prudent levels.
In this view, bank leaders themselves could be relied upon to manage their institutions prudently — after all bankruptcy is not in the interest of shareholders. Previous bank failures were the result of failure to measure risks properly, or failures of internal communication and control.
So the job of regulators was to set out principles and ensure banking institutions had adequate internal systems and controls, then allow senior management to ensure the overall level of risk was prudent.
This reliance on internal risk-management systems has proved to be a huge error. As Greenspan himself noted recently, bank leaders had not acted in the careful manner he had expected when he pushed for them to be freed from the old, more restrictive regime.
As a result, credit control will be much more intrusive in future. As noted in a companion column [ID:nLQ274403], there is renewed interest in some form of overall credit policy to limit the quantity of credit within the economy and ensure it is consistent with macroeconomic stability.
But intensive contra-cyclical credit controls will only work if they are imposed on a broad range of institutions and on a worldwide basis — otherwise the banking system will arbitrage between regulators, and business will be booked in the jurisdiction with the “lightest touch”.
This is precisely what happened in the last decade, when the FSA, and the Commodity Futures Trading Commission in the United States, arguably led a race to the bottom among regulators to offer the most generous regime in the hope of creating a competitive advantage for their home jurisdiction and winning more business.
So any new credit control instruments will need to be implemented on a multilateral basis and agreed through the Basle Committee on Banking Supervision, in tandem with the Madrid-based International Organisation of Securities Commissions .
The Basle Committee’s updated Capital Accord has already been rendered moot even before it has been fully implemented. Basle II’s decision to allow banks to rely on their own complex internal risk control systems when judging how much regulatory capital they need to hold now looks quaint.
Of the three pillars in Basle II — capital requirements, market discipline — the third now looks wholly outdated, and elements of the first and second need substantial re-working.
Some form of Basle III will be needed to buttress the contra-cyclical credit instruments which national regulators and central banks will deploy to manage the credit cycle and limit debt to GDP ratios to more safe levels.
Basle III needs to settle on an agreed range of credit instruments and credit-creating institutions that will be subject to regulation, how regulation will be applied on a counter-cyclical basis, the respective roles of supervisors and bank management, and how to ensure against regulatory arbitrage.
BANK REGULATION AND MONETARY POLICY
The failure of Basle II process bank regulation at multilateral level has been matched by failure among national regulators. The events of the last 18 months have demonstrated that a credit-fuelled banking crisis cannot be contained within the financial sector and has potential to destabilise the rest of the economy severely. Credit policy is a matter of macroeconomic strategy, not just financial regulation.
If credit expansion has the potential to destabilise the real economy, and the liabilities of much or all of the financial system are contingent liabilities of the central bank and the finance ministry as lenders of last resort, then the quantitative control of credit is arguably too important to be left to a financial regulator, such as the FSA or the U.S. Office of the Comptroller of the Currency and U.S. Office of Thrift Supervision .
Quantitative credit control needs to be brought within the remit of the central bank, so that credit expansion can be adjusted in tandem with interest rates (and indirectly in response to changes in government fiscal policy) to ensure internal, external and financial balance simultaneously.
While banking regulators may still have a “tactical” role in supervising prudential management and risk controls within individual institutions, the “strategic” role of limiting credit extension across the financial system as a whole to a safe level is too important, and properly belongs to the macroeconomic managers at the central bank.
Recent regulatory trends have seen institutional responsibility for financial regulation dispersed across multiple institutions, and separated from monetary policy at the central bank. This trend may now have to be reversed.
A more consolidated and intensive approach appears inevitable. Proposals to combine the various US regulators or at least to give the Fed over-arching responsibility as a super-regulator for the financial system have received widespread support, though the details of institutional reform have yet to be agreed.
In the United Kingdom, the wisdom of separating financial regulation from the Bank of England and passing responsibility to the FSA is increasingly questioned. The need for a lender of last resort support to a wide range of institutions, and the macroeconomic consequences of a widespread debt crisis, have pushed the Bank of England back into the heart of financial regulation.
If a new instrument for controlling the quantity of credit is eventually implemented, it will probably have to be managed out of the central bank. The FSA may retain responsibility for the prudential supervision of individual banking institutions, but the overall framework of control will need to be set by the central bank.
EMERGING REFORM AGENDA
If proposals for regulatory reform are to stand any chance of being implemented, they will need to move beyond a sterile debate over market-led discipline and innovation versus stodgy heavy-handed state regulation.
They will have to recognise that collective action problems and moral hazards in the credit creation process make some form of quantitative control essential. The system needs to achieve a financial balance alongside internal balance and external balance, and for that it needs to develop a third instrument, credit policy, alongside the traditional monetary and fiscal policies.
Credit policy will need to act directly on the volume of credit created, and amount of risk, independently of its price, which is the province of interest rates and monetary policy.
It will need to be contra-cyclical and apply to a broad range of institutions to be effective.
It must be dynamic, capable of being modified as the financial system evolves and pioneers new ways to circumvent the existing controls.
It must also be applied on a multilateral basis to prevent the type of regulatory arbitrage which occurred in the late 1990s and 2000s.
The Basle Committee is the most promising forum for reaching agreement. But Basle III will need to be developed much more quickly than Basle II, which took more than a decade, has still not been implemented fully, and risks becoming a stillborn historical curiosity, a monument to an age which has passed.
That suggests Basle III should focus on a much simpler set of credit control instruments, and eschew complexity in favour of a blunter but more effective approach. Crude but effective safeguards may be preferable to interminable arguments and theoretical elegance.
Source: Reuters by John Kemp 26.01.2009
Filed under: Banking, News, Risk Management , Bailout Lesson, Banking System, Basel II, Basel III, Black Swan, Economic Crisis, Financial Crisis, Financial System, Monetary Policy, Regulation, Reuters Thomson, Risk Management, US Financial Meltdown
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