Tuesday, 16 March 2010

How Should The World Financial Markets Be Regulated In Future?

One of the questions that has been asked in only a few circles is “How much are regulators to blame for the current financial crisis?”

The focus of attention has been on the banks (and financial institutions such as AIG where apparently 15 people were the main cause of the debacle) and their management, especially on management who took risks that they shouldn’t (in hindsight) have.

Amidst all the furore, however, other parties (governments, investors, borrowers, rating agencies and regulators) have not asked themselves whether they also bear some responsibility for the massive asset bubbles that took place towards the end of the first decade of the new millennium.

Regulators occupy a difficult position. They need to act as “party poopers”, raining on everyone’s parade when times are good and people don’t want to hear bad news. From what I can see of the UK markets, not only did the regulator lack the strength (or political backing) to make a difference, it was also staffed by people who did not understand the markets they covered and who lacked the internal communications to pass information where it was needed. I have read of supervisors in the US regulator (the “Fed”) complaining of lack of resources. Clearly, something was wrong in at least these two organisations.

Since 9/11, the approach seemed to have been more on preventing money-laundering than on really assessing the inherent risk in businesses. Regulators were staffed primarily by academics or specialists because they couldn’t pay the fees for people who had been in the markets.

I’ve written about the regulatory issue before (see Regulating the City 23 September 2009 and Whither Risk & Regulation? 14 April 2009) and still feel that regulators need to examine themselves as much as banks. We need regulators who:
• Understand their markets;
• Are properly paid so that they don't end up rushing out to the banks;
• Are independent of political interference BUT;
• Have political backing;
• Can impose proper sanctions;

The last is starting to come to fruition, but I fear that the rest will still take time. Markets move fast, and regulators will always be playing “catch up”. The best they can do is hire (and pay for) those in the markets who understand that market. Regulators tend to be inward-facing (i.e. focussed on their domestic market). They need to cooperate on a global scale (only just starting to happen).

Speaking to those in the UK financial services market tells me that their regulator still doesn’t “get it”, that they want academic and regulatory knowledge first, understanding of markets and how businesses fit together second. Specialisation will continue to dominate experience. Until this changes, I fear that the UK at least is condemned to “second-class supervision”.

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Wednesday, 10 March 2010


In my last post, I set out five questions for the future of the global financial services market. They were:

1. What we want of our future global financial services market;
2. How it should be capitalised;
3. How it should be regulated;
4. How it should be paid for;
5. What happens when an institution fails.

In this post, I will tackle the first.

I once used to think that no one looks after banks if they go down. In the past, this was the case (witness Barings, BCCI). However, I was remarkably wrong when the latest crisis happened as I (along with many others) had failed to spot that the global financial and economic systems at large had become so closely intertwined that allowing a major player to fail now would be like amputating a leg without anaesthetic or proper surgical instruments. If the victim survived the shock and loss of blood, they would have to adjust to a very different way of doing things.

In the same way, the loss of several major players on the world financial stage has resulted in a massive shock to the system and, after rushing the victim to the ER, we’re now in "intensive care mode".

We need to decide what we want of a global financial system both now and going forward. It's not enough to legislate for sins of the past (did Sarbanes-Oxley really achieve anything, except to drive companies to list on the London Stock Exchange rather than on the NYSE?). We need to think of the future and of the unthinkable. Knee-jerk reaction of the type we've seen in many cases will only do more harm than good.

So where do we start?

Back to basics: whatever you may think, banks are a vital part of any economy in that they: provide a safe haven (in theory) for savings; promote transformation of excess capital (savings) into products that add value to the economy (loans to businesses); provide an efficient mechanism for moving wealth from one party to another (payments); support global trade with an international network of either their own branches or of correspondents. They require specially trained staff who adhere to a set of rules which prevent them doing things that other organisations might consider “normal business”.

In other words, they're an integral part of the global and national economies. Think of them as the plumbing or wiring in a building. You might notice if this failed for a short time, but if the whole lot failed permanently, you would be faced with re-wiring and/or replumbing the whole building. So it is with banks. They're capable of causing a major disaster and so need the same safety precautions that plumbing and wiring do. We want our lights to work when they're meant to and the same for our taps. We don't expect the house to be burnt down when we turn on the lights, or flooded by faulty pipework.

We require our plumbers and electricians to be trained and certified competent. We don't expect them to be millionaires (and don't pay them enough to be so), but we do expect them to do the job properly with good quality materials and need inspectors to make sure this happens before the building is declared fit for purpose.

We want our infrastructure to work properly, and this includes basic financial services: savings, payments, loans, investments. The rest is icing on the cake.

With the loss of confidence, banks are lending neither to each other nor to the economy, and yet an economy needs finance to grow.

Banks need to remember the responsibility that goes with their position in what is a strategic industry. Much has been made of the distinction between the "low risk" and the "high risk" activities that the large players undertake, and that it is the "high risk" activities that risk bringing them down (but equally, allowed them to make the stellar profits that we saw in the past). Was this the case with Northern Rock? The risks that banks undertake need to be clearly understood, controlled, funded and ring-fenced. I'm not saying that banks shouldn't undertake riskier activities as this is what often leads to innovation, growth and prosperity. However, it seems clear that where this prosperity is confined to a select few, we should question its real value to society.


Banks are a strategic industry and risks need to be managed in this light. We need to adjust our expectations of what we expect them to do, the profits we expect them to earn and how much we expect them to lend.

We want them to innovate, but not at the potential cost of loss of confidence. We need to respect the fact that because credit is cheap, they shouldn't use it to undertake riskier lending.

We want a global financial system that supports economic growth by lending to activities that contribute to this without undue risk.

We want managers who have been bankers all their lives, not brought in from fast-moving consumer goods companies to develop sales. If that means not lending to people who can't pay back, or making less in profits then so be it.

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Wednesday, 3 March 2010


The world is starting to emerge from the global economic recession (some countries faster than others), but in terms of what brought the global financial system to its knees, what have we learnt and what are we doing about it?

The answers to these questions seem to be "a lot" and "not much" respectively.

The UK FSA and other regulators have come up with insightful commentary on the causes of the implosion in the financial services markets. Their remarks are true and diverse. They're also available on the various regulators' websites.

I was talking to one of the world's regulators recently and was struck by the absence of any vision of what needs to happen though. True, bonuses have been limited (and, no doubt, will be in future) and we've seen calls for increased capital, liquidity, governance, oversight and "living wills" (with variations on these major themes).

What we haven't seen is an understanding that what we've got today is the result of banks and economies developing over the centuries on their own, and regulators having to wrap themselves around the results. True, in most cases, these developments were the result of customers needs, regulatory developments, global trade expansion, economic and technological progress.

What we have now is a chance to ask:

1. What we want of our future global financial services market;
2. How it should be capitalised;
3. How it should be regulated;
4. How it should be paid for;
5. What happens when an institution fails.

Free market economics will necessarily drive much of this, and the last thing we need is government alone deciding how the system should run (Volcker, take note). Government and regulators do have a part to play, but so do the markets. We're still in the midst of mass hysteria where fingers continue to be pointed at bankers' bonuses as a useful diversion from other systemic flaws of which the politicians (and regulators) of the world would rather we remained as little aware as possible.

I will look at each of these questions in a series of articles over the next few weeks and attempt to put a framework on them. Suffice it to say, any suggestions (constructive, of course), are welcome.