John Plender in the Financial Times offers a hit list of what he views as the obvious priorities for financial services reform and assesses the odds of them being implemented. It’s a useful exercise, but also a sobering reminder of how difficult it is to effect change in an industry that has proven to be very effective in co-opting its minders.
From the Financial Times:
History tells us that the scope for regulatory reform is directly proportionate to the severity of the crisis. The rescue of Bear Stearns and the deepening impact of the credit implosion on the real economy make it clear that radical financial re-regulation now looms. The snag is that radical remedies may not gravitate towards the right problems.
Consider some obvious systemic flaws exposed by recent events. Clearly, the Basel capital adequacy regime needs greater emphasis on liquidity. It could also usefully address the problem of pro-cyclicality in banking whereby risk appetites increase as the cycle cranks up.
Then there is the extent to which new-fangled paper has deserted exchanges for more opaque over-the-counter markets, a phenomenon that left Bear Stearns too interconnected with important counterparties to be allowed to fail.
Also urgently needed is an overhaul of the incentive structures that encourage strategies that generate steady returns upfront at the cost of exposure to low-probability, but potentially catastrophic events. More crudely, bank bonuses need to be clawed back where profits turn to losses.
The degree of leverage in investment banking has been too high. It could readily be curbed. And in the retail market there needs to be greater due diligence in the origination of loans. The list could be extended at will.
But, how much of this short agenda will actually find a radical and coherent regulatory response?
The size of the liquidity shock has been such as to guarantee serious change in the Basel II framework on this score. No doubt capital requirements will become more stringent too. But when it comes to pro-cyclicality, Bill White of the Bank for International Settlements identified a fundamental difficulty in a lecture last month at the London School of Economics: what he dubbed “the will to act”.
The Basel regime is heavily influenced by big bank lobbying. It is worth recalling that when Peter Cooke, then of the Bank of England, was driving this regulatory process, efforts to give liquidity a bigger role were stymied by the banks. They argued that liquidity was hard to define and measure, and that comparisons across national boundaries would lead to regulatory arbitrage. It was easier to build a consensus around the adoption of capital as a key indicator of financial soundness in the consensual process of international co-operation.
So, in the land of the one-eyed banker, capital became king. The liquidity measures that might have mitigated the damage in the current crisis went begging.
With pro-cyclicality it may prove to be the same story. And it will be compounded by tax authorities who fear anything that looks like generous provisioning and by accountants who have their own agenda on this subject.
As for the opaque OTC markets, it would be relatively easy to force business back on to the exchanges, where counterparty risk is minimised. Institutions such as mutual funds could be prohibited from investing outside exchange traded, Securities and Exchange Commission- registered paper. Leaving aside the issue of whether this is desirable, it would certainly unleash a ferocious lobbying campaign from the banks because the OTC market is where the money is. With the US Treasury in the hands of Henry Paulson, late of Goldman Sachs, whose influence in Washington is second to none, the odds are surely stacked against.
Distorted incentives, meantime, take us back to the dilemma of Warren Buffett, the great investment sage, when he owned a chunk of Salomon Brothers. His attempt to install a rational bonus scheme came close to precipitating an immediate exodus of key talent. Buffett retreated. Hard to believe the regulators can succeed where he failed.
Where we will get radical change in a US election year is on due diligence in lending to the retail home owner and investor. The risk is that it will be clunky, bureaucratic and end up shrinking the volume of mortgage lending even more. So keep your expectations in check. changes to the institutional architecture and individual regulations will be subject to compromise and fudge. Radicalism will be flawed.