Is Better Regulation The Way To Avoid Future Financial Crisis?

At the outset, it appears necessary to identify the issues which need to be contended with in order to come to a reasoned conclusion on whether increased or improved regulation would prevent future financial crisis. Broadly speaking, financial regulation can be described as the system of supervision, and occasionally intervention, which oversees the financial system, and aims to maintain financial integrity. The question seeks to know whether improving or tightening this system could prevent future financial crises such as that which erupted in 2007, and has subsequently led to some of the world's most high profile banking institutions to the verge of collapse, with the likes of Lehman Brothers being consigned to history. This essay will argue the case for careful and slight changes and tightening of the system, as this could provide added global financial security, but will also outline the risks of going too far for the UK and global economies.

Undoubtedly recent history has shown us how fragile the banking system and the global economy can be when put under intense pressure. The popular view is that the "credit crunch" which began in 2007 was the result of excessive lending to the "sub-prime" market in products such as mortgages over the course of several years, which exposed the banks to excess liability, which came home to roost in late 2007 when the first of the major financial institutions collapsed in the USA. The collapse quickly focussed attention on other banks who were frantically assessing their asset portfolio, and finding a large gap between what they had insisted they were holding, and what they actually had. Arguably, the subsequent recession and its ramifications can be traced in its entirety back to this sequence of events.

So, it must be asked, why did the regulators (the Financial Standards Authority in the UK) fail to see this coming? And, would a different system prevent such crises?

It is important to note that, by way of example the FSA works on several principles, one of which is proportionality. This means that the Authority will only seek to restrict, where the outcome is proportionate to the aim to be achieved. To put this into context, would it have seemed proportional for the FSA to attempt to implement restrictions upon banking activity in 2006, following more than a decade of stable economic growth, and at a time when the banks had been trading freely and making billions of pounds of profit? Arguably not and therefore it may be necessary to view the FSA (and other financial regulators across the world) as naive to banking activity, as opposed to responsible for the failure of the system.

So, to take the point that the regulators may have been naive to the reasons behind the ever increasing profits of the banks, namely the excessive lending to those without the ability to pay it back at high rates of interest, which had the effect of creating high profits in the short run and exposing the system to huge risks in the long run, would increased regulation solve the problem?

Arguably it would. If the Banks are subject to higher levels of restriction, and are forced to make all available data on levels of risk available to the FSA more frequently, the effect would undoubtedly be greater transparency, and would make it more and more difficult to take on unjustified risk. The regulators could also use a carrot and stick policy. The incentive placed before the bank could be tax breaks for the institutions which are able to frequently show that they are working to limit the level of risk they take on and are able to balance this against the need to make a profit. The likelihood is that such a system, were it to be implemented, would also produce greater efficiency in the companies, as they seek to increase profits. The knock on effect of this is likely to be greater stability in the sector brought about by greater confidence and willingness to invest in institutions which are seen to be the safest bets. The stick in this example could be a report published by the regulators every six months, or as frequently as is needed to instil confidence in the market, which would rank the banks and financial institutions on the basis of safety, much in same way as schools and universities are placed in league tables based on success. In the abstract this represents a valuable idea. It would mean that the banks would have no choice but to conform to a safety first approach, or risk being at the bottom of a league table which would be widely available in the public domain, which could in turn lead to investors in certain banks moving their assets to those banks which were meeting objectives.

However, there are reasons why this works in economic theory and not in practice. Theory allows for variables and important facts to be disregarded in the search for a one size fits all approach to the market economy. The theory itself forgoes the intertwined reality of the modern economy and sees the situation thus: if X performs more efficiently and soundly than Y, and is seen to do so, then the market will use the "perfect information" garnered to it, and reward the more efficient supplier by moving its assets to that supplier, forcing the inefficient supplier from the market. However, the reality in this instance would be very different were it not to be controlled. In the light of the 'credit crunch' and the failure of several banks, the system is especially weak. In the event of such information being put in the public domain, without sufficient explanation of it, the likely effect is to be that panicked investors remove their assets. As they do, and the bank becomes more and more fragile, it is likely to fail to honour large loans made other banks, hence weakening them, and once again causing the system to be put under more intense pressure. This simple example serves to illustrate two things. Firstly that the banking system is so intertwined, that any attempt at what might be deemed aggressive regulation could cause yet more harm to the system, and hence any such implementation must be carefully thought out. Secondly, that the system itself can never place theory above the practical human reactions, which arguable cause the huge profits, and huge losses which the banks have been known to make, when devising new systems of regulation.

A possible alternative to this has been voiced by Mervin King, the current Governor of the Bank of England. In light of the recent crisis which has led to Government bail outs to the tune of billions of pounds, which have been imitated around the world, he believes that the natural result has been to create a "too big to fail" culture in the industry, which in turn may lead to further crises in the future as the banks are now aware that they can rely on Government support if they have difficulties. This is especially so now that Governments around the world have bought into the major banks on a huge scale. What he proposes is not increased regulation, but a complete overhaul of the banking system, whereby banks would separate their everyday humdrum business which is low risk, from their highly risky ventures. In such a scenario, it can be presumed that the 'everyday' element of the business would be the portion which would be "too big to fail" and would also be the least likely to do so, hence limiting the risks to the rest of society in the process. This would in essence create a system whereby: "institutions can fail without imposing unacceptable costs on the rest of society".

The necessary result of such a programme, if properly and fully implemented, would be that banks could continue their high risk activities, in which they would essentially only be able to stake the money of those willing to take the risk. Meanwhile the ordinary member of the public would know that their money was safer than it had previously been. Also, a somewhat unconsidered by-product of such action would be that regulating the industry would be likely to get easier. In effect, the regulators would know exactly where the riskiest capital was being held at any one time, and would also know, from audits and other measures, whether or not such business was being carried out properly.

Whilst this idea has benefits to the overall stability of the market, it also creates many problems in itself. It is important to remember that banks are, for the most part, global entities. They operate in markets the world over, in fierce competition with each other for market share. Generally speaking such entities thrive in any market where the currency and economy are stable. Therefore, it is clear that the any action to radically reform the banking sector would have to be done on a truly global stage. If not there could be truly disastrous economic consequences. Looking objectively, and disregarding any pomp or history, what is there to differentiate between doing business and paying tax for the privilege in London, from doing exactly the same in Frankfurt, Toronto or Shanghai. Any move for change which is taken unilaterally could lead the banks to consider their position in that market, and rather abruptly move some or all of their business to a more 'friendly' economy. The effect of this for Britain, which has staked its future in the services, and especially financial services sector, could be to chip away at the keystone of the national economy, and leave in its place very little with which to compete with the rest of the globe.

It is this need for global harmony which is likely to be the long term problem if any idea with the likely effect of that stated above is likely to be successful. Each country has its own views and its own solutions to the problem, and therefore agreeing to one unified policy is likely to be a huge stumbling block. One only needs to look at the successive rounds of global talks on climate change prevention initiatives to see that, where there are possible economic ramifications, there is likely to be a great deal of heated debate, and very little agreement, especially in the short term. Also, the people who aren't at the discussion table are just as important as those who are. To take what may seem an unrelated example, the American company Berkshire Hathaway, one of the most successful investment companies in history, is not based on Wall Street, or even in New York, but more than a thousand miles away in Nebraska. This illustrates the point that institutions can set up anywhere and not necessarily in the most financial fashionable area. There is in theory to stop any euro-zone city such as Prague becoming Europe's financial hub as a result of lax regulation at the expense of, for example London. Hence, the point must be emphasised that, in order to implement any such strategy, it is necessary include every potentially viable State which the banks could move business to in the talks.

A point to consider at this stage is whether or not any such intervention is necessary. As is always the case in times of crisis, the need to find those responsible leads to widespread condemnation of the entire sector. In reality, it may be true to say that, due to the crisis, a few bad apples were caught out, and removed from their positions of power. It is likely that some high profile bankers would put this argument forward, were they to have the freedom to speak candidly on the matter.

Or, to look at the issue from a different perspective, it may be true to say that regulating this aspect of banking more heavily would restrict this type of high stakes gambling, but it has been remarked in this regard that within the banking sector there is a high level of "creative imagination" when it comes to thinking up new ways of taking risks , which would themselves later have to be regulated. Arguably though, this argument is weak, as there are clearly discrepancies in the system of checks on the banking sector, which should be addressed so as to provide greater security against this type of problem.

If regulation is the answer to the problem of financial crisis, then how should it be implemented? An important issue here is that of banker's bonuses. It has been argued that the huge pay outs offered by banks to their employees contributed quite significantly to the recent crisis. It certainly stands to reason that employees of major institutions are more likely to take risks if they know that the likely short-term effect will be positive, which will in turn lead to inflated remuneration at the end of the year. Currently the regulatory position is that there is no express requirement to ensure that a firm's remuneration strategy is consistent with sound risk management . Reform on this matter is already being discussed by the FSA in recent consultation papers.

One approach which could be taken to regulate the system, would be to take the view that the huge bonus culture in the UK, whilst having obvious negative connotations (as considered in brief above), may bring the best talent in this field into London, as opposed to other competing financial centres, which does have a knock- on beneficial effect for the overall economy. On the basis of this, it may be preferable to follow a more subtle approach to regulation as opposed to an outright ban on large bonuses. One way of doing this may be to stagger bonus payments, so that on the one hand, the banker receives part of the bonus payment, with the likelihood that they will receive the rest; but on the other hand, if it is subsequently found that the transactions of the employee in question were dubious, then the remainder of the payment can be withheld. The workability of such a plan requires some consideration, but it may be possible for the staggered portion of the payments to be held by the FSA or equivalent body, in much the same way as the deposit protection scheme is used for tenancy deposits. This would also have the somewhat fortuitous knock on effect, that the sum of the money held by the FSA could be placed in a high interest account, which would in turn earn interest which could be transferred to the treasury. This could fund the scheme and in turn earn substantial rewards for the public purse. Another approach, tackling regulatory reform generally is being considered by the G20. Broadly speaking, the approach being considered is one of acceptance of the existence of such risk driven institutions, but limiting the intrinsic risk of such institutions by requiring them to hold more liquid capital and placing a cap on the amount of debt the bank can be laden with. Several problems with this though are inevitable. As discussed above, there is a real need for the global harmonisation in such matters, as otherwise the measure will immediately face huge obstacles. Secondly, it is very difficult to know how much capital any institution will need to hold at any one time. By way of an example, it is likely that immediately before the onset of the most recent financial crisis that most estimates as to how much capital a bank would need to hold in reserve would be far from the true amount. This is an issue which may be overcome by greater transparency between the banks and the regulators. It is unlikely, especially in the current climate, that it would be up to the Banks to self regulate the issue, as they have quite clearly failed in spectacular fashion in this regard.

To conclude, there are several potential solutions and safeguards which could be put in place, whether regulatory or otherwise, in order to attempt to mitigate the risk of future financial crises. This essay does not present an exhaustive list of such possibilities but does seek to elucidate a few workable solutions. The ideal position would be to be able to look upon a system whereby success and stability is fully rewarded and encouraged, whilst the type of large scale institutional failure which detrimentally affects the global economy is guarded against and punished fully.