Regulation, regulation, regulation
This is the second of two posts on matters discussed at the ICAEW's recent conference on the Future of Banking.
Bad behaviour by banks was the primary cause of the 2008 financial crisis. Victoria Saporta of the PRA describes the pre-crisis period as the “partying phase”. Banks increased their leverage, in some cases to more than 60%, which left them very vulnerable to even small shocks to asset value. And they reduced their liquid assets, which combined with their high leverage made them highly exposed to damaging runs. But banks were not the only partygoers: household debt/income ratio grew to over 160%, concealed by low mortgage spreads that did not reflect the true risk of the lending.
In contrast, the aftermath of the crisis is a time of “healing” - repairing damaged banks and fixing the vulnerabilities that existed pre-crisis. Since the crisis, banks have been improving their capital and liquidity positions. There is a popular perception that this has been at the expense of lending to the wider economy, but in fact the global increase in banks’ capital ratios has been mostly driven by accumulation of retained earnings, not by restricting lending. Banks are now in a much stronger position than they were even a year ago.
But it’s not over yet. Extensive changes are being made to the regulatory environment within which banks must operate. Structural reforms aimed at segregating activities regarded as "risky" from vanilla deposit-taking and lending business are being introduced in the US, UK and Europe. Macroprudential regulations intended to make balance sheets safer are also being tightened: banks already face higher capital and liquidity requirements, and further measures are being discussed. And conduct regulation - perhaps the most intrusive of all forms of regulation and supervision - is taking shape in the UK.
Structural reform of banking is enormously popular. There continues to be a romantic belief that smaller banks are safer, behave better and serve the economy better, despite the absence of any real evidence to support this. Large universal banks are cordially hated by the general public on both sides of the Atlantic. This is perhaps understandable in America, where there is a considerable tradition of small banking and large universal banks are a relatively recent innovation: but it is really not comprehensible in Europe, where universal banks have been the mainstay of the banking system for a very long time. Nonetheless, there is a widespread belief that if "risky" investment banking activities can be segregated from "safe" retail banking activities the banking system will be protected from future failures. This is simply not true. This comment from Mike Trippett of Numis Securities is telling:
“One of the things I am alarmed by is the idea that retail banking can do no wrong, while investment banking is the casino that got us into this mess. Retail banking is an intrinsically unstable model. And what about everything that goes on between retail and investment banking?” – Mike Trippett
The Parliamentary Commission on Banking Standards' report into the failure of HBOS identified bad retail lending as the primary cause, and observed that ring fencing would not have prevented its failure. Indeed ring fencing would not have prevented the failure of any UK bank in the financial crisis.
It is by no means clear that structural reforms will deliver sufficient benefit to justify their cost. The fact that retail banking is as corrupt as investment banking renders the argument that separating the two will eliminate "cross-contamination" from investment banking to retail banking moot. Even deciding which activities to segregate is fraught with difficulties, as UK reformers are discovering. And as all large UK universal banks are shrinking their investment banking arms in response to political pressure, it is questionable whether there will be much left to ring-fence by 2019 anyway. James Chew of HSBC and Mike Trippett both argued that ring-fencing could be a waste of resources, and although it is easy to say of Chew, at any rate, that "he would say that wouldn't he", I am inclined to agree with them. The benefits of structural reform simply may not justify their cost and disruption. We should not hesitate to ditch regulatory reforms that become pointless due to other changes, however popular they are with the general public.
Prudential regulatory reform
Prudential regulation is something of a moving target. Basel 3 is currently being implemented, but discussions are already proceeding on further changes – what Steven Hall of KPMG, presenting a technical session on macroprudential regulatory developments, described as “Basel 3.5” – and even a new initiative. Basel 4 is “emerging from the mist”.
Implementation of Basel 3, CRD4 and other regulations in Europe is complicated by the drive to create a banking union in response to the Eurozone crisis. But the banking union itself is in danger of foundering on political disagreements. There is a real risk that national regulatory reforms could be short-circuited by the failure to agree on the shape of banking union, to the detriment of European bank customers.
But even without the additional complication of European banking union, the sheer scale and extent of regulatory change is breathtaking. There seems to be no area of the financial system that is not either already undergoing regulatory change, about to implement changes or for which changes are being discussed. Prudential regulatory reform is a simply enormous international initiative - or perhaps more correctly, a set of initiatives.
One of the worrying features of the current shape of regulatory reform is the continuing reliance on national regulators and systems for what is an international business. Large international financial institutions will potentially have to comply with regulations in a number of different jurisdictions, some of which may actually be conflicting. The cost overhead of complying with several different regulatory agendas is likely to be considerable. And it is likely to create opportunities for regulatory arbitrage. We saw how London became the location of choice for the likes of AIG prior to the financial crisis because of its favourable regulatory regime: the practice of choosing the location with the most advantageous regulatory regime for different areas of the business is likely to become more prevalent, not less, as national regulators deliver the reforms demanded by politicians, some of which may be more determined by cultural prejudices and popular beliefs than from a dispassionate evaluation of the facts.
To make matters worse, the Parliamentary Commission on Banking Standards has recommended that banks produce two sets of audited accounts, one for regulators and the other for everyone else. This is because regulatory reporting requirements differ from statutory reporting requirements - needing more extensive off-balance sheet analyses, for example, and different instrument valuations. The PRA has suggested that publishing regulatory returns would eliminate the need for two sets of accounts. I really hope so. It's a complete waste of resources. Presumably the PCBS doesn't realise that the cost of such unnecessary duplication would ultimately be borne by customers, shareholders and other stakeholders?
A further risk arising from extensive regulatory and supervisory change is staff shortages. Steven Hall expressed concern that the EBA did not have the staff to do everything that the European Commission expected of it, and John Hitchins commented that the ECB would struggle to staff its new supervisory function adequately. It seems we may not have enough Lilliputians to tie down our banking Gulliver anyway.
Regulation of "conduct" is a rather more nebulous concept than prudential regulation. This is not about making banks "safer", it is about making them behave better.
The FCA's risk outlook and business plan are truly terrifying documents. From design of products, to distribution systems, product and payment technologies and even funding strategies, the FCA oversees everything. And their remit isn't limited to regulated banks and insurance companies, unlike the PRA. Their scope is far wider, covering unregulated institutions as well: since its creation the FCA has done risk reviews on mobile banking, Self-Invested Pension Products (SIPPs), automatic fixed-income bond renewals and price comparison websites. The responsibility resting on the shoulders of these regulators is simply huge - and the responsibility resting on the institutions they regulate to keep them happy is equally huge. There is a risk that financial institutions will develop a "compliance culture" where ticking boxes is confused with risk management and complying with regulations is regarded as customer service.
To its credit, the FCA seems to be alert to this danger. Clive Adamson commented that "we want to know how firms run themselves, not how they control themselves". While he was broadly supportive of initiatives such as spot checks on conduct at point of sale - which is when mis-selling occurs - he warned about over-reliance on process changes. "The problem is not lack of process, it is behaviour," he said. "There needs to be profound cultural change".
Exactly how that is to be achieved by close regulatory supervision is not entirely clear, though the FCA does appear to regard its remit as more educational than coercive. It has run "treating customers fairly" roadshows and is currently running a programme of Business Risk Awareness workshops for smaller financial firms. It may be that the FCA's risk reviews and training programmes will help to generate the changes in behaviour that are needed in the financial industry. But there is no doubt about the intrusiveness of the supervision. And this forces me to ask two questions: 1) if financial firms are never trusted to do their jobs without supervision, how will we ever know if they can act with integrity? 2) how confident are we that the regulators themselves always act with integrity or in customers' best interests? Regulatory capture was a feature of the financial system prior to 2008. We surely cannot be certain that it will not happen again. Who is going to regulate the regulators?
The weight of regulation
Since the 2008 financial crisis, further damage to the reputation of banks has been done: mis-selling of consumer products and other bad behaviour such as the rigging of Libor has destroyed confidence in all forms of banking, retail as well as investment. As I write, new allegations of FX market manipulation are being made, and on the horizon scandals are brewing about the rigging of CDS markets and fixing of interest rate swap prices. It seems that bad behaviour extends into all areas of the financial sector. It is perhaps not surprising, therefore that new regulations to control behaviour in all areas of the business are being created.
But I wonder if it is all going too far. Steven Hall graphically described regulatory reforms as creating "buffer upon buffer upon buffer". Really, how many buffers does a bank need? The new capital structure has at least five....Hall wondered whether we are starting to see diminishing returns from “layer upon layer” of regulation. Mike Trippett worried that too much regulation would create an inflexible, compliance-driven culture: “There is still a need for a bit of old-fashioned banking intuition”, he said. And I found myself feeling oppressed by the sheer weight of the regulation now imposed upon our financial industry.
If our financial behemoth is so dangerous that we have to tie every part of it down, what use is it, really? And if supposedly "private" banks cannot do anything without the scrutiny and approval of hundreds of public sector regulators, to what extent are they really private institutions anyway? Are we simply using overbearing and intrusive regulation to maintain a system that in reality is no longer fit for purpose?
Forrest Capie of Cass Business School called for simpler, less intrusive regulation and for banks to be allowed to fail. “Capitalism is the best system we have,” he said. “But within it, you have to be allowed to fail. Banks haven’t been allowed to do that for a long time”. Indeed the point of some of the regulatory changes is to enable banks to fail safely. But much of the rest is concerned with preventing them from failing at all.
You can, of course, prevent a financial institution from failing. Simply turn it into a pure deposit-taker which invests only in safe assets. And there are voices out there that would like banks to become exactly that. If your priority is to protect deposits and payments, then preventing banks from doing risky lending is obviously the right way to go. But we don't like banks that don't take risks. We complain that they won't lend to SMEs or to first-time house buyers. Taking risk is in the nature of banking. As long as credit intermediation and maturity transformation remain the business of banking, managing risk will remain at its heart.
Regulation cannot solve all the problems of banking, and a completely risk-free future is neither attainable nor desirable. Micro-regulating banks will not teach them to manage risk effectively or behave with integrity. That will only come as a result of the long, slow process of culture change. Yes, they have betrayed our trust: but in trying to prevent them from hurting us again, we may render them completely useless.
Restoring trust in banking - Pieria