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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