Features : After the Storm

Global crisis: For the biggest names in banking there has been nowhere to hide from the current turmoil.

With each new phase of the current financial crisis, a new area of neglect of regulation is disclosed. The discovery of an apparently massive fraud at the hedge fund run by Bernard Madoff, the former chairman of Nasdaq, looks set to trigger a crackdown on an investment area that has been notable for its lack of regulation. In mid-December it was disclosed that some $50 billion had allegedly disappeared from Madoff’s investment pot.

Regulators are likely to focus on the complex spread of jurisdictions inhabited by funds such as Madoff’s. Such funds are typically managed out of a major financial center such as London or New York. However, investors’ money is often kept in companies in low-tax, low-transparency offshore centers such as the Cayman Islands, Jersey or the Bahamas. The funds are administered in havens like Dublin or Luxembourg.

This triple pillar of jurisdictions creates enormous problems for a regulatory system that is based largely on national regulators covering their own country. The risk of regulatory oversight falling between the cracks is great. What is clear is that the need for a review of global institutions has never been more urgent.

One institution on which much will depend in the shake-up of global financial regulation is the Basel system. Basel is the series of risk-based rules devised under the auspices of the Switzerland-based Bank for International Settlements that governs banks. However, when the global banking system stumbled, much of the blame for the failure was heaped on Basel. Indeed, there was a widespread call for Basel to be completely abandoned and replaced with a new architecture.
Now it is widely felt that Basel needs to be amended rather than replaced. “Do we need more rules and regulation?” asks Peter Hahn of the Cass Business School in London. “No, we need smarter regulators. We need the existing rules to be better and more intelligently applied.”

The Basel rules should form a basis for banking regulation, confirms Steven Lewis, the chief economist at Monument Securities, “but they are not quite sufficient.” Indeed, Lewis believes that Basel may be responsible for some of the complacency and over-trading that took banks over the brink in recent years.

Banking regulation falls into three parts, according to the Basel arrangement. The first provides a format for the relationship between regulatory capital and risk, the second assesses the relationship between risk and remuneration, and the third places a requirement on banks to furnish useful information on a basis of transparency.

Banks rather than regulators should take the blame for recent failures, says Hahn. “That capital was based on risks, and those were misunderstood. The rules that provided an assessment of capital didn’t include trading portfolios. Banks had a lot of liquid assets on their books that they traded through. They didn’t need a lot of capital for that because they thought they could get rid of those tradable assets,” he explains. “Many of the losses in recent times occurred on the trading books. We have learned a lot more about how the rules should work. We need to refine the risk capital measures rather than throw them out. We need smarter application of the rules.”

There are some notable gaps in the Basel rules, says Lewis, who argues that they fail to deal with some fundamental aspects of banking behavior and risk. “There’s a feeling that the Basel rules may form a basis for going forward, but some features of that system contributed to the problems that arose. The pro-cyclical character of the capital requirements, the fact that banks are able, through retained profits, to build up their capital in good times makes them feel very comfortable and leads them to do all kinds of unwise things,” he explains.

“The problem with this market-based approach is that when the markets see the banks’ capital shrink during the bad times, they are not going to say, ‘This is what happens in the economic cycle.’ They will say, ‘Better be careful, there could be an accident soon,’” Lewis adds.

Some economists go further than Lewis and argue that the crisis shows the Basel rules are inadequate. Prime among such critics is the UK monetarist economist Tim Congdon. He puts it bluntly: “The Basel rules have failed. Some people say, if only Basel II were being implemented, this crisis wouldn’t have happened. I mean, for Heaven’s sake! The Basel rules are … like a tower of Babel in international banking. You won’t get all these national regulatory systems under one uniform set of regulations.”

Congdon is far from alone. The abandonment of domestic regulatory structures in favor of an international super-regulator, like the abandonment of Basel, was also demanded by many observers at the heat of the crisis. Indeed, it could be argued that Gordon Brown, the UK prime minister, continued to push such a point in his recent address to the G-20 group of countries. But other voices argue that a global regulator would encounter impossible conflicts of culture, and tight local regulation would serve as a more effective brake on banks’ unrealistic ambitions and techniques. “An international approach can be a useful means to distract attention for politicians saddled with a highly embarrassing economic situation,” says Hahn, “but there are many complexities in implementing international regulation.” He says that social and cultural differences in banking practices foil the creation of a single set of global rules. “One rule doesn’t fit all, so rules need to be localized,” he says.

Bernard Madoff’s alleged “pyramid” scheme resulted in new banking losses.

Local Resistance
“If you have a global control function, the regulator needs the money to step in when a crisis boils up,” Hahn continues. “But I wonder how keen UK taxpayers would be to bail out a foreign bank.”

Domestic authorities will also have difficulties with such an approach, Hahn says. “If the international super-banking regulator being prescribed by some were to take over Citi and demanded it be broken up, somebody in Washington might say, ‘That’s our biggest bank, we can’t have guys based in Switzerland deciding what happens to our bank.’”
Hahn does not rule out the possibility that structures may be introduced to facilitate cross-border regulation, but he insists that “there is no substitute for local regulators governing their own banks.”

Some are blaming the loss of a close relationship between a local regulator and its local banks for the crisis in banking, says Congdon. “The central bank is the regulator of the banking system. It watches both liquidity and solvency of banks, and it makes sure that there are never crises of this sort because it is close to the banks, and it lends to them in all sorts of discreet and quiet ways.”

Such a localized view of regulation is, however, flatly contradicted by Willem Buiter, a former member of the Bank of England’s Monetary Policy Committee and an academic at the London School of Economics. “You should get as close as possible to regulating on a global level,” he says. “There needs to be a contact with the global regulator in each market segment, at least for those businesses that cross borders.”

A central and global regulator faces practical obstacles, says Buiter, but he asserts that a regulatory authority could be created for each power bloc as a first step to the global banking regime. For example, the European Union could establish a Europe-wide regulator. “This entity would strike agreements on standards with regulators in other key places like the US and China, the Gulf Cooperation Council countries and India,” he says.

The ferocity of today’s crisis could distract politicians and regulators from the necessary rethink of its flawed structures and approaches. “Regulators are so busy fighting fires that they are missing the need to do something about the institutional failures that brought about today’s crisis,” says Lewis. “If these challenges are not thought through deeply, I see no reason why more and even harsher crises should not quickly arise and put the system at even greater jeopardy.”