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However the major international banks regarded the 8% capital requirement imposed by Basel as impossibly onerous, and believed that the Accord unnecessarily restricted their move into profitable new areas of finance. Consequently, from the middle 1990s they vigorously lobbied the Basel Committee for a new agreement, the Basel II accord, which would allow them to carry out their own risk management and leverage themselves more than their smaller brethren. Unsurprisingly, their lobbying worked.
Equally unsurprisingly, the new capital standards haven’t. The risk management methodology blessed by Basel II, that of Value-at-Risk, has been found to be an excellent way of measuring risk – except when markets are actually risky. Consequently the capital requirements imposed by VAR in the name of Basel II are so much waste paper. Also, large banks have been proved no more sophisticated than small ones. It is notable that the only difference between the subprime write-offs of Merrill Lynch and Citigroup, among the largest and most sophisticated banks in the industry, and Sachser LB, a German landesbank so insignificant that it played no measurable economic role even in its home region, was an extra zero tagged onto the end of Citi’s and Merrill’s loss figures. Naturally, Sachser LB had to be ”rescued” by a larger partner – but so did Citi and Merrill, the larger partners in their case being several dubious sovereign wealth funds.
The theoretical edifice of modern finance was magnificent and apparently indestructible. Its implosion in the last six months has been nothing short of spectacular, triggering misguided predictions and analyses by those in authority worthy only of Mother Shipton. To say modern finance’s destruction resembles the sinking of the Titanic would be trite, and in any case insults the magnificent engineering of that doomed, but beautifully built and almost flawless vessel. Instead, let us remain with the nautical motif, and compare it with the sinking of the British warship HMS Captain in 1870.
Unlike the Titanic, HMS Captain was seriously flawed as an engineering concept...
...
Rather than bury financial innovation in the inner depths of institutions so large it will be either lost or misused, a conscious attempt should be made to recreate the organizations that acted as primary financial innovators for two centuries: the merchant banks. Subject to tight banking regulations themselves, and limited in the amount of capital they could deploy, these institutions should be certified by the central bank and, once certified, granted some privilege similar to the discounting of acceptances that would put them on the same basis of creditworthiness as the behemoths. They would thus be the main centers of financial innovation, albeit on a modest scale, ceding the new markets they created to the behemoths when those markets had become commoditized and well understood even by the slow-witted behemoth managers – in other words performing the same function as the pre-1986 London merchant banks, without necessarily being located in London.
...
Needless to say, good central bank legislation would also not have permitted the Fed to cease reporting M3 in March 2006, just as the awful effects of its excessive expansion were beginning to become glaringly apparent. Without the compass of broad money statistics, proper monetary steering becomes impossible.
Thus in New York as well as London, banking regulation needs to be overhauled. The objective should be a system similar to that of the pre-1998 German Bundesbank, in which monetary credibility was total and regulatory oversight draconian."
Regulating the un-regulatableBy Martin Hutchinson
March 03, 2008
SourceMartin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005) -- details can be found on the Web site www.greatconservatives.comThe complex and ongoing collapse in the US securities markets, and the extraordinarily expensive demise of Northern Rock in Britain, signify gross failures of banking regulation on both sides of the Atlantic. As regulation has grown more complex, it has become notably less effective. In the post-financial-holocaust world that we will shortly enter, how should it be done?
Traditionally, banking regulation was quite simple, because it was enforced by oligopolistic markets. The Bank of England was the universal regulator; it had little statutory power but over a “cup of tea” could enforce compliance with the most conservative banking standards. The strength of the Bank of England lay in its informal control of the British banking “club” – a bank which defied the Bank of England would find itself in severe difficulties in obtaining lines of credit with other banks, or in attempting major corporate business.
The United States is in some ways a more interesting example. From 1791 to 1836, the First and Second Bank of the United States could and did enforce banking standards by determining at what price they would take the notes of other banks. Since in order to finance trade a bank’s notes needed to be acceptable in distant centers, a bank which lent over-aggressively would find the Bank of the United States no longer willing to accept its notes at face value, which would substantially increase its costs of financing trade.
From 1837, with the Bank of the United States no longer in existence, this system broke down – the free market in money reigned supreme, with notes trading at varying discounts and no central clearing house. Then in 1862 the National Banking Act instituted regulated national banks, and provided for a truly common currency. Around 1900, J.P. Morgan exercised a similar influence to the Bank of England over the US financial system, although US banks whom Morgan thought lacked “character” were always better able to survive than British banks on whom the Bank of England frowned.
This admirable system of highly informal regulation on both sides of the Atlantic began to break down in the 1920s, when US houses wrecked the international issues market by being over-aggressive in peddling loans to Latin America. However, the New Deal brought tighter banking regulations to both sides of the Atlantic and the combination of tight statutory regulation in the US and loose regulation and continuing oligopoly in Britain worked well until the middle 1960s. At that point, the invention of the Euro-market, together with the replacement in 1966 of a very strong Bank of England Governor Rowland, Lord Cromer with a series of weak ones brought the existing regulatory system for the first time into question. The U.S. houses, tightly regulated at home, found they could operate much more freely in the European market, and those without banking licenses need pay little heed to the Bank of England’s opinion. The result, from 1969 in both Britain and the US was a series of unpleasant scandals and bankruptcies followed by a decade-long downturn in the financial services business.
The British government responded by moving to a statutory system of regulation similar to the US; this had the effect of wiping out its merchant banking community which had existed for over 200 years. Internationally, the unexpected, mishandled and litigation-rich collapse of Bankhaus I.D. Herstatt in 1974 led to a demand for internationally agreed capital requirements and trading standards. The first Basel Accord, which standardized capital requirements worldwide, was fairly simple, but took little account of the financial innovations that were already sweeping the banking business. It went into effect in 1988 and had a notably useful effect in emerging markets, where local banks were discouraged from overleveraging themselves, as had previously been their practice.
However the major international banks regarded the 8% capital requirement imposed by Basel as impossibly onerous, and believed that the Accord unnecessarily restricted their move into profitable new areas of finance. Consequently, from the middle 1990s they vigorously lobbied the Basel Committee for a new agreement, the Basel II accord, which would allow them to carry out their own risk management and leverage themselves more than their smaller brethren. Unsurprisingly, their lobbying worked.
Equally unsurprisingly, the new capital standards haven’t. The risk management methodology blessed by Basel II, that of Value-at-Risk, has been found to be an excellent way of measuring risk – except when markets are actually risky. Consequently the capital requirements imposed by VAR in the name of Basel II are so much waste paper. Also, large banks have been proved no more sophisticated than small ones. It is notable that the only difference between the subprime write-offs of Merrill Lynch and Citigroup, among the largest and most sophisticated banks in the industry, and Sachser LB, a German landesbank so insignificant that it played no measurable economic role even in its home region, was an extra zero tagged onto the end of Citi’s and Merrill’s loss figures. Naturally, Sachser LB had to be ”rescued” by a larger partner – but so did Citi and Merrill, the larger partners in their case being several dubious sovereign wealth funds.
The theoretical edifice of modern finance was magnificent and apparently indestructible. Its implosion in the last six months has been nothing short of spectacular, triggering misguided predictions and analyses by those in authority worthy only of Mother Shipton. To say modern finance’s destruction resembles the sinking of the Titanic would be trite, and in any case insults the magnificent engineering of that doomed, but beautifully built and almost flawless vessel. Instead, let us remain with the nautical motif, and compare it with the sinking of the British warship HMS Captain in 1870.
Unlike the Titanic, HMS Captain was seriously flawed as an engineering concept. She was an experimental ironclad battleship; her designer Captain Cowper Phipps Coles designed her with revolutionary turret guns and a freeboard that was deliberately kept exceptionally low, even by the standards of the early ironclads (American readers will remember that the USS Monitor, eight years earlier, also suffered from this flaw.) As well as screw propulsion, the Captain was equipped with a full set of masts and sails, which together with the turret guns made her top-heavy. Her flaws were magnified by shoddy construction; she came in 870 tons over design and with a freeboard of only 6 feet 6 inches instead of the planned 8 feet. Consequently, while stable in calm seas, she overturned on September 7, 1870 in a moderate gale in the Bay of Biscay, drowning all but 17 of her crew of 500. In its poor design, shoddy construction, misguided experimentation and general un-seaworthiness modern finance is the Captain not the Titanic; further use of the prototype should be scrupulously avoided.
The system of financial regulation needs to be completely reworked. No longer should the behemoths of the market be allowed to give themselves greater privileges than medium sized banks. Nor should untested financial theories be incorporated into regulations until a major bear market has proved them seaworthy. Instead, all assets for which a bank is responsible should be carried on its balance sheet, as should the market value of all liabilities, contingent or otherwise, even if they are offset by corresponding assets. Strict regulations should be imposed on maturity and currency mismatches, and trading in equities should not be permitted by institutions whose deposits are guaranteed. No exceptions should be permitted to these regulations. Overleveraged blunderers like Fannie Mae and Freddie Mac should not be allowed to evade banking regulation; since they do banking business, they are banks, albeit banks with an entirely unhealthy concentration of risk in one sector.
Rather than bury financial innovation in the inner depths of institutions so large it will be either lost or misused, a conscious attempt should be made to recreate the organizations that acted as primary financial innovators for two centuries: the merchant banks. Subject to tight banking regulations themselves, and limited in the amount of capital they could deploy, these institutions should be certified by the central bank and, once certified, granted some privilege similar to the discounting of acceptances that would put them on the same basis of creditworthiness as the behemoths. They would thus be the main centers of financial innovation, albeit on a modest scale, ceding the new markets they created to the behemoths when those markets had become commoditized and well understood even by the slow-witted behemoth managers – in other words performing the same function as the pre-1986 London merchant banks, without necessarily being located in London.
Institutionally, both London and New York’s regulatory systems have been found wanting. In London, the Northern Rock case has proved it hugely damaging to separate the regulation of institutions from the responsibility for their bailout. The Financial Services Authority, responsible for regulation, was at no financial or career risk when things went wrong. Conversely the Bank of England was called on to bail out an institution which it had no hand in regulating. The British taxpayer, the ultimate source of bailout funding, was not consulted at any point.
In New York, the main problem has been the conduct of monetary policy itself, which has been inordinately lax for over a decade. The Fed’s dual mandate, to preserve price stability and full employment, is in practice an excuse for politicians to browbeat the monetary authorities into excessive laxity, while the abandonment of monetarism by the Fed in 1993 allowed spurious justifications for excessive money creation to multiply like weeds. The Fed must be given a mandate of price stability alone, and must be instructed that, while the United States may not currently be on a gold standard, monetary aggregates, narrow and broad, should not be allowed to grow faster than nominal Gross Domestic Product, and ideally not significantly faster then real GDP.
The objection that monetary aggregates cannot be used as a guide to policy is entirely true in the short run, entirely false in the long run. Whereas a particular monetary aggregate may well grow exceptionally fast or exceptionally slowly for 6 or even 12 months, off-target growth over an 18-24 month period indicates that something has gone seriously wrong, and that policy changes need to be made. In the case of dollar M3, the aggregate began to grow excessively rapidly from about February 1995, rising 7.0% in the year to February 1996 and 7.6% in the following year, both significantly faster than the growth of nominal GDP (4.5% in 1995 and 5.6% in 1996). By late 1996 it should have been obvious that tighter policy was needed, even if an exuberant stock market boom had not also hinted this. Indeed, it was obvious; Fed Chairman Alan Greenspan’s “irrational exuberance” speech was made on December 4, 1996. At that point, Greenspan should not have been permitted to ignore the matter; he should have been compelled by statute to tighten monetary policy until M3 growth once again fell below the growth in nominal GDP.
Needless to say, good central bank legislation would also not have permitted the Fed to cease reporting M3 in March 2006, just as the awful effects of its excessive expansion were beginning to become glaringly apparent. Without the compass of broad money statistics, proper monetary steering becomes impossible.
Thus in New York as well as London, banking regulation needs to be overhauled. The objective should be a system similar to that of the pre-1998 German Bundesbank, in which monetary credibility was total and regulatory oversight draconian.
Bankers are by nature greedy people, who will use any loopholes in regulation to enrich themselves, without regard to the risks to the public. Better therefore that regulation should be draconian and without loopholes than that the spurious “innovation” of the last three decades be allowed to continue.