We need rules, not regulation

There must be a full moon, because the lunatics seem to be running the asylum.

First, we have the fuss over Fred “The Shred” Goodwin’s pension.  I suspect the reason Alistair Darling has waded into the debate – and perhaps for the timing of Fred’s tasty annuity becoming public knowledge in the first place – is to distract the media from the far more important issue of the UK’s dodgy asset insurance scheme (or whatever it’s called).  I have no idea whether the taxpayer or the banks’ shareholders are being ripped off (though I am cynical enough to suspect the latter, since this would be consistent with the UK’s policy to date), but I do know one thing: the basically correct strategy of muddling through is most definitely not enhanced by debate in the media! Now, I agree that Fred’s pension is far too generous.  But the problem of excessive inequality is a general one – broader even than the whole area of executive remuneration, of which Fred’s compensation is by no means the most extreme example.  Inequality should therefore be addressed as by general measures – for example, raising the minimum wage aggressively.  When it comes to raiding Fred’s pension pot, I think we should be more concerned about fundamental principles such as the fact that our society is based on honouring contracts.  The question we should be asking is: “Where does this lead?”

Second, I know the UK political and chattering classes, shamefully and counterproductively, simply blame “greedy, reckless” bankers for the Great Crunch.  Indeed, the UK leads the world in focusing blame – I’ve heard from no less blessed lips than those of Barack Obama himself, words along the lines of “we have [i.e. “the American public has”] to get used to the fact that 30 or 40% annual increases in the value of our homes are a thing of the past”.  Nevertheless, there is a quiet, sober voice even in the UK’s debate that points out that we are all to blame, for taking on too much debt.  I therefore find myself feeling like Jack in Cuckoo’s Nest.  Why am I the only one who questions the wisdom of supporting those who demand the right to spend money they don’t have?  I refer of course to those noble campaigners who are demanding the return of charges levied on them for unauthorised overdrafts.

It seems that, rather than address the causes of the Crunch, the thrust of government action is aimed at regulating the banks even more than before. I’ve seen several pieces commenting on this, all in favour.  For example, before getting distracted by Fred’s unfeasibly large pension pot, Rob “Breathless” Peston was gasping for air after hearing the FSA’s thoughts about regulation.

What Rob simply doesn’t appreciate is that the banks did not want to get into this situation.  He writes:

“The only role for the FSA at the time – according to Turner – was to make sure that the structures, systems and processes of the banks were ticketyboo. So it verified stuff like whether there were a sufficient number of bodies in the risk-management department; or whether the right kind of management and risk information was being gathered and disseminated to the right people; and so on.

But it wasn’t apparently proper for the FSA to challenge banks on whether they should be growing so fast in the mortgage market, or loading themselves up with collateralised debt obligations manufactured from toxic subprime loans, or funding themselves to an ever-increasing extent from the sale of mortgage-backed securities.

I’m so shocked that I’ve come over all cockney. All I can think of to say is ‘can you Adam-and-Eve it?’

And my own answer is ‘no’, if I’m honest.”

Peston is seriously misleading the public – quite a lot of them judging by the number of comments on his blog.

It is not the purpose of regulation to second-guess banks’ strategy.  The principle the FSA was trying to employ was correct.  They should be focused on ensuring:

1. That banks’ internal controls are in place – the internal risk departments have a voice, and so on.  Perhaps the FSA failed to achieve this at HBoS, for example.

2. The banks provide information for external controls to function.  External auditors provide a similar function, and part of the FSA’s role is to make sure they are able to and are doing their job properly.  The true external control on banks like RBS are the capital markets (i.e. investors), assisted by analysts and the media.

If the FSA simply tries to look over the shoulders of bank executives, as Peston suggests, they will be entirely ineffective.  Not enough media commentators and investors believed that: banks were “growing [too] fast in the mortgage market”, or that there was a problem “loading themselves up with collateralised debt obligations manufactured from [with hindsight] toxic subprime loans, or funding themselves to an ever-increasing extent from the sale of mortgage-backed securities”.  And neither did the rest of us.  The idea that the FSA will (ignoring entirely the evidence of the past) in future be staffed entirely with bold contrarian visionaries is, frankly, absurd.

It would be far more effective for the FSA to concentrate on establishing rules that will allow the existing mechanisms to control the banks to operate more effectively.  For this reason the UK government is wise to resist calls for nationalisation, thereby ensuring that Lloyds’ and RBS’ shares remain listed, and that bond purchasers in the banks also understand they are taking on a risk greater than lending to the state.

Let’s look at a few of the things that have gone wrong:

1.  Reliance on capital markets.  The liquidity crisis took down Northern Rock in 2007, for example.  But it wouldn’t have taken much to avert this one.  No-one knew the Bank of England would fail to act as lender as last resort.  If reliance on the money markets (as opposed to deposits) was so stupid, why didn’t the FSA issue guidelines limiting banks’ reliance on them?  Investors would have run a mile from banks breaking such rules.  As I’ve said before, I think it was a mistake for the Bank not to act as lender of last resort right at the start of the crisis in 2007.  Furthermore, I simply don’t understand how all banks can rely on deposits. The money markets are always going to be an important source of bank funding, since large pots of sterling are held all over the world (larger than necessary, in fact, thanks to our trade deficit).  No amount of second-guessing of banks’ strategy is going to make up for a lack of clarity as to the circumstances when the Bank will provide liquidity.

2. Excessive property lending.  In which HBoS, in particular, appears to have indulged.  If there’s an asset bubble, then some will have bought or lent excessively – by definition!  What’s needed are policies to prevent asset bubbles.  Since the UK (through its definition of the sort of inflation which is targeted) and the US (e.g. Greenspan, explicitly) have decided to ignore asset price bubbles until they burst, maybe, just maybe, we should examine this policy, before spending £100s of millions on more regulators.  I doubt, myself, whether there’s much to be done to prevent stock-market or commodity bubbles.  The former are very difficult to identify and it’s even more difficult to employ appropriate  levers to control them; the latter (commodity prices) are – even more than stock-market bubbles – a global phenomenon.  But surely we can devise policies to prevent excessive rates of increase in the price of property –  particularly residential property?

3. Takeovers at the top of the market.  Such as RBS of ABN.  This is a) an old problem and b) not specific to the financial services sector.  Why the FSA thinks it can solve this one (assuming it does), or that it’s the appropriate body to do so is beyond me.  95% of RBS shareholders voted for the ABN  takeover, so perhaps, if Fred has to spend his old age in a bothie on a remote Scottish island, he should, when he fancies reminiscing over a dram of whisky, be able to hike to his neighbours, those who were in charge of our pension funds, who also apparently thought the ABN takeover was a good idea.  A large proportion of British adults had a significant stake in RBS through their pensions.  Perhaps public debate in such corporate actions as mega-takeovers (and corporate pay!) would be encouraged by giving more beneficiary holders of shares a vote at AGMs.  A good place to start would be private shareholders who generally use nominee accounts.  Modern IT systems could surely be employed to enfranchise such shareholders at relatively little cost.

So, leave Fred alone, work out what went wrong and change the rules.  It’s madness for government to try to second-guess bank, or any other, executives.  An entire industry of financial analysts, advisers, journalists and so on already exists to do that.

I’m rather disappointed to see Willem Buiter in the FT jumping on the bandwagon.  He writes:

“The notion that markets, including financial markets[,] could be self-regulating, by properly incentivising CEOs and Boards of Directors, and through market-discipline is prima facie suspect.” (Buiter’s point 4)

but then – to my mind – contradicts this by saying:

“Regulation can only take place on the basis of independently verifiable (public) information.” (Point 5)

Whilst he makes a number of sensible points, Buiter has a touching faith in public discourse. He notes, for example, that:

“There is a need to regulate financial innovation…. To get a new instrument or new institution approved, there will have to be testing, scrutiny by regulators, supervisors, academic specialists and other interested parties, and pilot projects.”  (Point 12)

Peston mentioned the evils of mortgage-backed securities.  But the banks believed they were diversifying risk.  Do we seriously believe that outsiders would have reached a different conclusion?  Of course not.  Besides, if you try to do someone else’s job, you inevitably end up thinking like them.

Sure, there are a lot of things that should be done.  We should, for example, recognise that sufficiently large hedge funds can pose a systemic risk.  But that’s something that should have been done after (or even better, before) LTCM failed in 1998!

But, apart from the huge cost of all these regulators, I strongly suspect they will merely define the parameters for the next financial crisis.  I’m particularly concerned by the idea that:

“Counter-cyclical capital and liquidity requirements or leverage ratios should be implemented…” (Buiter’s point 15).

As I’ve previously pointed out, this will simply allow asset bubbles to inflate even further.  And, as I noted some time ago, the measure will not be as easily applied as most people seem to think: we never know where we are on the cycle (though it’s likely to peak just after we stop increasing the counter-cyclical buffers, believing that “it’s different this time”!) and, most problematically, we never know how bad it’s going to be.  The pressure is still on banks to increase their capital in case things get even worse.  No-one’s saying: “Lucky our capital reserve was 6% and not 4%!”.  Banks will only be able to reduce their capital when things start to improve – that is, when they no longer need to!

No, these demands for more regulation are a distraction from identifying the causes of the Great Crunch, and instituting policies that really will make the financial system more stable.