More Turmoil - Not International Regulation - Needed

Includes: BAC, C, IEV, LEHMQ, MS, WFC, XLF
by: Simon Smelt

The G20 finance ministers promise a lot more regulation of financial markets - that is internationally coordinated - to ensure the markets don't go haywire again. The G20 - as the EU’s de Larosière report and many others - seeks to soothe markets and outline steps to reduce the chances of future turmoil. But such ideas fail to address a contradiction in the nature of banks and thus how we address risk. In some ways, we need more turmoil, not less.

Banks are both holders of other people's money and, through fractional banking, the key agents in increasing the supply of money and its velocity of circulation. Hence, we want banks to be prudent and, indeed, conservative, institutions. This is the image of the traditional stone bank building with Corinthian columns and marble halls. This is the image of institutions that do not fail, thus allowing depositors and central bankers to sleep at night.

As allocators of capital, and thus change drivers in the modern economy, and as businesses like any other, we need financial institutions to be flexible risk takers who experience the consequences of bad decisions and can go bust. Schumpeter famously wrote about the creative destruction of the market place and that is what we are seeing now. Those who overreach – such as Lehman Brothers (OTC:LEHMQ) – are destroyed. Giants who are sluggish and poor at assessing risk and innovation – and Citibank’s (NYSE:C) share performance has been weak for the past decade – die.

The balance may be difficult to strike but this doesn't mean we stop trying. Alas, the suggested mass of regulation does just that. Certainly, financial institutions need a clear and robust regulatory framework to operate within. That framework needs to be actively patrolled by competent bodies and policing action taken as necessary. Banks as depository institutions need stricter rules.

But the G20 finance ministers, the EU, and various other parties want to go much further. They want to make financial markets safe through regulation. This itself is an unsafe idea for three reasons.

First, we need innovation, dynamism and risk taking in financial markets. We can look to have a relatively safe end of the pool with retail banks but this does not mean there should not be a relatively risky end. The regulator’s role is to try and ring fence the safe end – which has not been much done of late – rather than try to spin rules to catch all. And the regulation of the safe end should be for national not pan-national bodies. In the current crisis, we have heard about the advantages of the Canadian and Swedish approaches to banking. If interational banking regulation was run out of Washington or Frankfurt, these variations would not have emerged. Nor would the Icelandic disaster. But that is the point: failure has to be allowed. Variety and change in regulatory frameworks allows different approaches to be tested. That is risky. But what is even riskier is to adopt one universal and all embracing set of rules. That allows no variety and assumes the makers of the rules are omnipotent – a Stalinist form of financial control.

Second, detailed international regulation is difficult to achieve and does not work well. Immense effort has been put into the Basel I and Basel II accords setting international standards for banking. They have proved easy to evade. Perhaps, we know better now – but that is only learning the lessons of the last crisis, not the next. And, as anybody who has been involved in international negotiations knows, an international committee may aim to design a race horse, but will lucky if it manages to produce a camel. The idea of an international framework to govern financial institutions may sound attractive but realizing it will be fraught and the results disappointing.

Third, government entanglement in financial markets is dangerous. The more complex and far reaching the regulation, the more government(s) are embroiled in that which is regulated. That unleashes all the domestic and international political forces concerned. For example, Fannie Mae (FNM) and Freddie Mac (FRE) were promoted as vehicles that could provide a stabilizing solution to the Savings and Loans crisis. Instead, they became immense de-stabilizers of financial markets as they sought to meet political goals.

Risk is inherent to financial markets and handling it is core business to financial institutions. Regulation can help safeguard against factors which exacerbate risk but it cannot remove risk.

We have seen the failure of a model which combined minimal regulation, poor enforcement, the two Basel accords with their evident gaps, the U.S. government sponsored Fannie Mae and Freddie Mac pumping out poor quality loans, and the Greenspan “put” on monetary policy. This does not tell us that tight regulation and enforcement, combined with government support and hence direction of banks, will restore the financial sector to health. Indeed, in seeking to promote safety, such an approach will only provide the illusion of safety. It will prevent the resuscitation of a healthy banking sector and preserve the failed zombie banks provided they play by the rules. Capital will be inefficiently allocated, locking in poor economic growth and thus (without inflation) high levels of debt.

The debris needs to be cleared away and fresh risk taking and innovation allowed within simple and robust frameworks at national level. That may not be soothing to jangled nerves but creative destruction should still be the expectation with, if necessary, retail deposit taking operating under stricter rules in order to obtain government guarantees for depositors.