FINANCIAL REGULATION: Internal affairs

This summer the US and the UK produced new evidence of an industry that had gone out of control in the years leading up to the market implosion of August 2007.

In June, Barclays stunned the market by announcing it would pay $451 million in fines for manipulating the key Libor interbank lending rate. Six other banks, including Royal Bank of Scotland, Deutsche Bank and JP Morgan, are in the frame for future punishment by watchdogs.

The uproar that followed Barclays’ revelation forced the departure of the bank’s chief executive, Bob Diamond, along with his chairman and chief operating officer. Barclays is also under investigation over payments it made when arranging its recapitalization by Middle Eastern investors in 2009.

Barclays’ bombshell followed JP Morgan’s admission in early May that it had suffered a big loss on complex credit derivatives – now estimated at $5.8 billion – at its chief investment office in London.

The so-called ‘London Whale’ loss was the first serious scandal to hit JP Morgan since the start of the financial crisis. Both Barclays and JP Morgan had been outspoken in warning against excessive regulation in response to the crisis.

Then the two UK banks with their reputations most intact were hit by US investigations into money laundering processes.

In July a Senate report accused HSBC of exposing the US financial system to money laundering, drug trafficking and terrorist financing, resulting in HSBC setting aside $700 million to pay fines. The following month, Standard Chartered, for so long untouched by the problems of its rivals, reluctantly agreed to pay $340 million to settle a New York regulator’s accusations that the bank had been hiding $250 billion of transactions with Iran.

How – after five years of measures design-ed to rein in the excesses of the bankers – did we arrive at this point, and where does it leave the process of re-regulation?

Peter Hahn, lecturer in finance at London’s Cass Business School, says: “Some of the issues arising now happened many years ago, and in some cases over many years, in an industry that went through a period of rapid growth and oftentimes was cheered ahead by almost all on the sidelines.

“In hindsight one of Basel II’s great failings was charging banks to regulate themselves, and the idea they would or could do so correctly was a fallacy. Much of what’s coming out now is just a case of catching up as we continue to gain a better understanding of what occurred. That’s governments, regulators and banks’ own management getting to grips with better detail of the industry they look over.”

Richard Reid, head of research at the International Centre for Financial Regulation in London, says there were doubts seven or eight years ago about whether Libor was an appropriate measure for interbank lending, but that it has taken time. “This was a particularly big crisis in a complex industry, and it takes time for potential malpractice to come to light,” he says.

“In a financial crisis, there tends to be a cycle of events with attention paid to stabilizing things and stopping the rot from getting worse by stabilizing systems and the economy, and then attention turns to other things such as growth and what do you want from your financial system.”

The revelations of JP Morgan’s huge loss on esoteric securities and of Barclays traders’ influence on bankers in its group Treasury function gave renewed force to calls for splitting trading and retail banking apart.

In the US, this takes the form of the Volcker Rule, incorporated into the Dodd-Frank legislation, with the aim of barring proprietary trading by banks. In the UK, the government has pledged to enact recommendations made by John Vickers’ Independent Commission on Banking to “ring-fence” universal banks’ investment banking and retail banking operations.

Big questions still surround both measures. It is not clear what activities will be allowed under the Volcker Rule or how it will be implemented. The UK government has accepted John Vickers’ proposals but, with anti-bank sentiment running high, it could take a tougher line than that set out in draft measures published in June.

Less prominent, so far, is the high-level group appointed by European commissioner Michel Barnier and led by Erkki Liikanen, governor of the Bank of Finland. Liikanen is working on recommendations to improve financial stability and consumer protection that could well include a Volcker- or Vickers-style measure.

THE GREAT DIVIDE

David Strachan, co-head of Deloitte’s Centre for Regulatory Strategy, says: “The direct linkages between the events of the summer and the debate about whether a universal bank should be split into retail banking and investment banking operations aren’t at all clear, but that hasn’t prevented policymakers and commentators from making the connection, and it has given renewed heat to that debate.

“There is unlikely to be a full split of retail and investment banking in the UK, but it is possible that the government decides on a more rigorous implementation of the ring fence than envisaged in the June white paper.”

The revelations of the summer came at a time when doubts and divisions were emerging about the effectiveness of the re-regulation push that has been in train since early in the crisis.

An IMF scorecard published in April showed that one of the six main reform programmes – improving and increasing banks’ capital reserves – was well advanced. Work on derivatives, data and regulating the ‘shadow’ system of non-banks that act like banks was behind schedule.

Despite public outrage at the renewed stream of news about banks’ malpractice, increased fears for the UK economy could also put national implementation of global goals on hold or see them watered down.

Reid says: “At the beginning of this year, 2012 was billed as the year of implementation. What we have actually seen in the course of the year is that progress has been made but deadlines are slipping, because it’s practically difficult to hit them or there are unintended consequences because of difficulties with the economy.”

In June, Barnier warned that a broad US definition of the scope of the Dodd-Frank act threatened international coordination on cross-border derivatives trades. Tellingly, he cited JP Morgan’s losses as an urgent reason to reach a settlement on what he dubbed the “extraterritorial” impact of national rules.

The European Union and the UK, Europe’s biggest financial centre, are also set for further conflict over regulation of the City of London after the European Commission announced plans this September for a eurozone banking union that would give greater supervisory powers to the European Central Bank.

Simon Gleeson, a partner at Clifford Chance, argues that concerns about conflict between national and regional regulators are overdone, and that squabbles over minor issues overlook the need to restore investor confidence in the banks so they are equipped to lend to support economic growth.

“What the world has done is to make giant steps towards a standardized model. In the areas where you have a lot of coverage about divisions, the arguments are about relatively small things. The Europeans always protest about US extraterritoriality – and it should be no surprise that there is grumpiness about that – but it cuts both ways because the US is just as unhappy about European extraterritoriality.

“You can tell the most important thing because it is left to last. If we don’t get a workable resolution regime for failing banks then none of the rest matters. It is slightly disgraceful how long it has taken to get broad consensus on resolution legislation between getting agreement and turning it into legislation. Once you have got a resolution regime, you can provide a fairly high degree of reassurance to investors about what is going to happen.”

REGULATION VERSUS COMPLEXITY

The lurid details of the recent scandals inevitably overshadowed a speech by Andy Haldane, the Bank of England’s executive director for financial stability, at the Jackson Hole central bankers’ meeting this August. But his points were the talk of the annual economic conference.

Haldane argued the financial system was so complex that no amount of regulation could hope to cover the potential risks. Furthermore, the more detailed the rules, the more opportunities banks had to push them to the limit. So if rules’ effectiveness has been overstated, or if they are in fact counterproductive, what is the alternative?

Hahn at Cass Business School says: “The debate about more rules or less rules is obfuscating a more serious debate about authority. The complexity of modern banking requires regulators to use their judgment more to say yes or no, but that means the rules might be different from one bank to another. If you’re uncomfortable with that, the default position is more rules.

“It is inevitable that we move towards judgment, but judgment can’t be unfettered and needs strong support and control.”

The potential trouble with regulators exerting greater authority was underlined when Haldane’s boss, Bank of England governor Mervyn King, forced Diamond out of Barclays. King was criticized by Andrew Tyrie, chairman of the UK’s Treasury Select Committee, for wielding arbitrary power even though the committee approved of the result.

The scandals, combined with scepticism voiced by Haldane, may also put pressure on regulators to take tougher action to hammer home measures. Reid argues this is necessary to reassure the public that the financial system benefits savers and borrowers over market participants.

“Have we gone too far in the correction of detail, or does the detail need to be better policed? What we will see is that a lot of regulators are in a better position to enforce regulations. They will demonstrate that they can pick up on malpractice.”

Haldane’s speech highlights international differences in how to toughen up regulation. While the UK and the European Union are concentrating regulatory power in their central banks, the US is unlikely to turn away from Dodd-Frank’s hard-fought 848 pages of new rules in favour of more discretion, despite apparent Republican opposition ahead of November’s election.

Gleeson says: “Dodd-Frank wasn’t composed of a small number of clearly identifiable propositions. It was enormous, sprawling legislation that dealt with a lot of things that had been hanging around for years. As far as we can see, the vast majority of Dodd-Frank will stay in place come what may.”

REAL CHANGE

Critics of policymakers’ attempts to re-regulate the financial industry argue that, despite the apparent deluge of new rules, little has changed. In the US, the top four banks – Citigroup, JP Morgan, Bank of America and Wells Fargo – now account for 62% of market share among the top 50 lenders compared with 47% a decade ago, and their combined assets have almost quadrupled to $2.9 trillion, according to SNL Financial.

Ross Levine, an economics professor at the University of California at Berkeley and co-author of Guardians of finance: making regulators work for us, argues the banks are correct in complaining about the cost of new regulations because these efforts are misdirected and will have little effect in the US.

Levine says: “It’s a few years after the crisis. The big banks are bigger and the investors in the banks have lost very little money. There are very few constraints on their ability to take on lots of risks, and I see very few changes in their incentives. They were bailed out with a lack of accountability for the individuals who made these decisions, and that means we are in a more precarious position than 15 years ago.”

The situation is more dangerous now, he argues, because the crisis has demonstrated that taxpayers will bear the burden of the banks’ mistakes when things go wrong – vastly increasing moral hazard.

“Yes, these institutions were too big to fail, but that is very different from bailing out the equity and debt holders. What has fundamentally changed in terms of the underlying incentives that caused the crisis? If I were a large equity holder or an executive in a bank, this crisis couldn’t have been dealt with in a better fashion.”

Levine argues that the financial incentives and corporate governance at banks need overhauling to remove the benefits of taking short-term risk at the expense of the greater good. The Federal Reserve also needs its own regulator to make sure it is not “captured” by the industry it is meant to regulate, he says.

“The financial sector isn’t evil; it doesn’t have a soul. The question is, can a society construct guide posts so that this powerful entity is incentivized so that resources are not funnelled into short-run profits of a very narrow group?”

In the UK, attention has turned to reforming the banks’ internal organization and behaviour after regulators told the Treasury Committee that Barclays’ continually pushed the rules to the limit and that its board ignored warnings. Tyrie, the committee’s chairman, is heading an inquiry ordered by the Treasury.

Deloitte’s Strachan says: “The events of the summer have focused the debate on an issue that wasn’t so much to the fore in the post-crisis response, and that’s governance. Certainly in the UK, there is a new focus on the culture of financial institutions. The chances of it taking root to the same extent elsewhere aren’t zero but they are still lower than was the case in the UK before recent events.”

BIGGER PICTURE

Much of the debate is, of course, centred on western markets where the crisis started and had its greatest impact.

To emerging markets focused on maintaining growth and satisfying the demands of their populations, capital and liquidity requirements and questions of corporate governance are not top of the agenda. Officials from these countries believe IMF papers such as June’s Too much finance? overlook their priorities, according to Reid.

He says: “For the emerging world it’s a very different debate. In many of these countries it’s about growing and deepening their financial systems to channel funds to rapidly developing economies and to support their aging populations. India, China and other countries will say, ‘We fully intend to comply, but in the near term we need to do other things’ or they will apply their own version.”

The scandals of the summer have added extra heat to a regulatory debate that was already complicated by international fissures and economic uncertainty. The results will keep bank bosses busy for some time yet.

Gleeson says: “It would be quite nice just to get on with banking business, but for those running the banks the next two or three years will be spent on internal restructuring, and it’s hard to see how that will do anyone much good.”