Duncan’s Economic Blog

Regulation

Posted in Uncategorized by duncanseconomicblog on March 18, 2009

The Turner review of financial regulation is out today. Unsurprisingly I haven’t had a chance to read all 168 pages it. But Alphaville have done a nice summary here, here and here.

The key points Alphaville have noted are:

• A cap on gross leverage (p. 67).
• Creating counter-cyclical capital buffers (p. 61) and the inclusion of “economic cycle reserves” in banks’ accounts.
• Regulating credit rating agencies (p. 76).
• Figure out a way to structure pay so that it doesn’t encourage excessive risk taking (p. 79).
• Regulation of SIVs and other offshore entities (p.70).
• A tougher approach from the FSA, including possible oversight of banks’ accounts (p. 88).

It all looks like a step in the right direction, although is not going far enough as I would like in terms of things stipulating a maximum loan to deposit ratio of 100% or making more of an effort to separate retail and investment banks. I’ll go into my thoughts on regulation at some future point.

But for the moment I thought I’d offer some quick thoughts on the 1997 financial regulations structure. Let’s start with the obvious, the banking crisis of the last 18 months shows that the system is far from perfect. However Britain is far from alone in this. We have seen nothing on the scale of Lehman Brothers, Bear Sterns or AIG. We have not assumed as much risk as the US has in Citi, Bank of America, Freddie and Fannie. I think the US, as another Western, complex financial system is the best example to use. No fewer than 25 banks failed there last year.

Light regulation was a mistake. There is no two ways about that. It was a mistake. Although I do find it somewhat rich when financial professionals say ‘it’s the government’s fault, they should have saved us from ourselves’.

Not enough people, and certainly not the opposition, made any attempt to fight the case for higher standards of regulation. Regulators, together with most of the economics establishment, had fully fallen into the intellectual black hole that is the efficient markets hypothesis.

To that extent I don’t think it would have mattered who regulated the banks; the FSA or the Bank of England. Let’s not get to rosy eyed about the BOE’s history of banking regulation either.
So was the decision to split responsibility between the FSA and the Bank of England a mistake? Those who claim it was are invited to read Mervyn King’s comments of September 2007, just before Northern Rock.

“But the source of the problems lies not in the state of the world economy, but in a mis-pricing of risk in the financial system.”

“If, in the wake of a shock to the financial system, the terms on which the financial system extends credit to the private sector become less favourable, then borrowing and overall demand would weaken. Other things being equal, that would lower the inflation outlook. Of course, other things are not equal. When the Monetary Policy Committee meets each month it reviews all the evidence on the outlook on inflation before reaching a judgment. The August Inflation Report implied that some slowdown from recent strong rates of economic growth was needed to meet the inflation target.”

“the provision of such liquidity support undermines the efficient pricing of risk by providing ex post insurance for risky behaviour. That encourages excessive risk-taking, and sows the seeds of a future financial crisis. So central banks cannot sensibly entertain such operations merely to restore the status quo ante. Rather, there must be strong grounds for believing that the absence of ex post insurance would lead to economic costs on a scale sufficient to ignore the moral hazard in the future.”

“If central banks underwrite any maturity transformation that threatens to damage the economy as a whole, it encourages the view that as long as a bank takes the same sort of risks that other banks are taking then it is more likely that their liquidity problems will be insured ex post by the central bank. The provision of large liquidity facilities penalises those financial institutions that sat out the dance, encourages herd behaviour and increases the intensity of future crises.”

I have a lot of time for Mr King as a monetary policy maker (although would argue he was too slow in cutting rates last year). I am less confident in his abilities as a regulator. To be discussing moral hazard and the principle of not intervening in financial markets as it might harm efficiency whilst a credit crisis was beginning seems a little odd.

I do not fully understand the current Tory position on this matter at all. In his speech last Friday David Cameron said:

So unless we want our economic lights to go out, it’s right and it’s proper that our banks are properly regulated by an organisation with the wherewithal, discretion, common sense, power and influence to keep them in check.

We are considering whether this job is best done by folding the regulator back into the Bank of England.

Now this all sounds very good on paper: the old system failed, so let’s give the power back to the Bank. There are however very valid reasons why the powers were taken from the Bank in the first place. In May 1997 the Bank of England was given independence to set interest rates. If the Bank is to once again become a financial regulator, to what extent will this independence be compromised? Will it have complete discretion on financial regulation? Or will it be independent for one task but not for another?

To me the debate we should be having now is what direction we want regulation to take, not the exact nature of the regulator. An equally important discussion is how we make sure monetary policy is better equipped to handle asset price bubbles. Debating at length the arrangements since 1997 seems a total red herring.

2 Responses

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  1. Richard T said, on March 19, 2009 at 8:50 am

    The Bank does not have a particularly good record as a regulator. BCCI anyone?

  2. tory boys never grow up said, on March 19, 2009 at 4:14 pm

    The other thing to bear in mind is that when the Bank did partially regulate the Banks (remember there were 12 other regulators as well before the FSA) – Banking Supervision was very much the poor relation within the Bank and was not always given the priority that it should have been – hence BCCI and Johnson Matthey. One actaully dreads to think what would have happened if King had been in charge of supervision at the same time as he was prattling on about “moral hazard”

    There has been a genuine problem in tripartite co-ordination – but however the deckchairs are rearranged that issue has always existed and will not go away – even if everything is in the same body the same people will not be responsible for markets, supervision of individual institutions and government policy.

    As is their want the Tories will try and mak hay with soundbites – but as usual any constructive proposals will be lacking.


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