The big bank theory

Is it possible to regulate the world's banking system? Richard Willsher investigates

Writing in the Financial Times on 8 June 2008, Timothy Geithner, president and chief executive of the Federal Reserve Bank of New York, said: 'Since last summer, we have lived through a severe and complex financial crisis. Why was the financial system so fragile, and what can be done to make the system more resilient in future?'

Geithner's remarks suggest his belief that the global financial system can be fixed and, as one of the most senior bank regulators in the world, he would have to believe it can. But the system is now so globalised that questions remain as to who is going to fix it. Having said that, is governance on a global scale really achievable?

The leading candidate for the top regulator's job is the Bank of International Settlements (BIS), the Switzerland-based central bankers' central bank. In April this year, its Basel Committee announced a series of measures 'to make the banking system more resilient to financial shocks'. They include:

• enhancing various aspects of the Basel II Framework (of recommendations on bank governance)
• strengthening global sound practice standards for liquidity risk management and supervision
• initiating efforts to strengthen banks' risk management practices and supervision related to stress testing, off-balance sheet management and valuation practices, among others
• enhancing market discipline through better disclosure and valuation practices.

No-one denies the scale and seriousness of the problems to be addressed, but getting banks across the world to implement such recommendations can be a long-winded process. For example, the BIS' Basel II proposals first saw the light of day in 2004, yet four years and a banking crisis further down the line they have still not been uniformly introduced by all of the world's banks.

However, the authorities that matter most are those that, in effect, manage the systemic risk in the global banking system - the US Federal Reserve System, the Bank of England and the European Central Bank. These are the principal conduits for liquidity. They stand by to provide cash and other forms of support to the most significant players in the world's banking system, and they are pretty much in agreement and work in tandem. But in the broader regulatory structure of the financial system, there is something of a disconnect.

Reserve judgement

Bob McDowall, research director at Tower Group, a leading research and advisory firm in the financial sector, points out that in the US, for example, there are no less than 12 regional Federal Reserve Banks although, by convention,  the New York one deals with systemic risk.

In addition, the Securities and Exchange Commission 'protect(s) investors, maintain(s) fair, orderly and efficient markets, and facilitate(s) capital formation.' There is, says McDowall, political rivalry between these regulators, and moreover the regulatory structure itself is a legacy from the 1930s.

As Geithner puts it: 'We need to streamline and simplify the US regulatory framework. Our system has evolved into a confusing mix of diffused accountability, regulatory competition and a complex web of rules that create perverse incentives and leave huge opportunities for arbitrage and evasion.'

The regulatory regime in the UK is no paradigm either. When the Northern Rock crisis arose it exposed not only failures at the Financial Services Authority (FSA), the bank's lead regulator, but also a significant and ultimately disastrous lack of co-ordination between the FSA, the Bank of England and the UK Treasury.

'When things go wrong, it's not necessarily that there isn't sufficient supervision or supervisory powers,' says Masoud Zabeti, head of the Banking and Finance Litigation Group at London-based law firm Mishcon de Reya, 'but that those supervisory powers are not used properly, or the supervisory authorities are not acting in accordance with their mandate… or being sufficiently proactive in the areas involved…'

A spokesman for the British Banking Association agrees, saying: 'The credit crunch has tested the international regulatory authorities, as well as those of individual countries… In the UK, we are facing perhaps the biggest shake-up of banking regulation in the past 30 years… The UK's tripartite system is not broken, but it needs to operate more efficiently. The critical lesson from Northern Rock is that regulators have the necessary powers, but need to use them decisively and confidently.'

In it together

If, however, the sharp shock of the sub-prime crisis in the US and its global reverberations is sufficient to galvanise the regulatory authorities in the US, UK and EU to work together more efficiently and effectively, will that be enough? McDowall says that putting in place overarching global banking regulations can't be done until the present crisis is sorted out, and that can't be achieved until the full extent of the banks' losses are revealed. 'We've reached a stage where we've had a sub-prime crisis, a liquidity crisis and a credit crunch. We're now at stage where there is a lack of faith or confidence in the financial institutions because they keep coming out with more bad news.'

Rebuilding confidence in the banks and their regulators are the twin challenges. But the elephant in the parlour is the unsupervised and substantially unregulated players. Hedge funds and prime brokers, who together account for a massive proportion of activity across all financial markets, pose very large risks to the financial system. The size of hedge fund transactions, the scale of the leverage they use and their influence in markets is a genie that the BIS, the Fed and other regulatory authorities are going to have try and stuff back into a magic, money-making lamp. 'The regulatory framework cannot be indifferent to the scale of leverage and risk outside the supervised institutions,' writes Geithner.

McDowall believes it is inevitable that they will be regulated. 'They have an impact on systemic risk management; that's the key thing. They have to become regulated institutions. They may need to be obliged to hold capital, for example. A second measure would be to put some constraint on the amount they can borrow against particular asset classes. It is because of the systemic risk they pose, and the system has to be protected at all costs.'

Danger looms

A danger, of course, is that once you have solved the current crisis and put regulation in place to ensure it doesn't happen again, a crisis arises due to another, unforeseen set of circumstances. James DeBono, a managing director at the London office of US financial sector advisory firm Duff & Phelps, says that any new regulation needs to be flexible because you cannot predict from where problems will arise. Over-prescriptive regulation would not be the right way to go.

Gary Dixon, managing director of consultants Resources Compliance, adds that part of the problem is unblocking the regulatory logjam. 'Which bit do you move in order to free it up? I can't see regulation on the scale that Geithner is suggesting being possible in the short term,' he says. 'I think a doomsday scenario exists because you could have paralysis of all sorts of markets and economies worldwide, with the complexity involved with some of the issues that are currently around. We are not there yet and if we start to go that way we will have to have more government intervention to keep markets orderly. As it is, a major, global, political effort is required to deal with some of these issues.'

Which is why stitching together a regulatory regime that is global, joined-up and effective would be difficult to achieve. Moreover, in a financial services culture that is very fast-moving and highly innovative, the regulators will most likely only ever be playing catch-up in an effort to keep pace with the industry they are charged with supervising. For all the best-laid plans of the Bank of International Settlements and regulators in the key financial markets, a global regulatory framework may be a long way off.

Richard Willsher is a financial and business writer with a background in investment banking.