Regulation, regulation, regulation

Regulation, regulation, regulation

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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

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.  

Another worrying feature is the extent of disclosures. In the drive to improve transparency, banks are producing reams of information. Reports & accounts run to hundreds of pages and trying to find useful information in them is like panning for gold: buried somewhere in a pile of dross are a few nuggets, but it takes a lifetime to find them. PwC’s John Hitchens suggested that focusing on communication rather than complying with regulation might be sensible: “If you come at your financial reports with a view to communicating what you are doing, you go a long way towards cutting clutter”. 

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. 

Conduct regulation

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.  

Related reading:

Restoring trust in banking - Pieria


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Frances, there is an argument for structure within retail banks. The point is retail banks undertake leverage lending, private placements, equity trading, and its this type of activity that leveraged up HBoS and frankly many other banks. Seperating this type of high risk lending / activity from retail banks that operate our deposit accounts and necessary payments systems is in my book a fantastic idea. Regulation must dictate what type of banking activity retail banks may conduct in order to remove this type of risk. The key with HBoS was its balance sheet funding structure (shallow deposit base, long overnight CP borrowing to plug the balance sheet), as well as the £40bn+ of losses and 30-40k job losses Gordon brown effectively left Lloyds shareholders and employees with - and the majority of UK pension funds are heavily invested in Lloyds as the one of the most widely held, if not 'the' most widely held security in the UK. The Grocer Hornby and Peter Cummings have a lot to answer for with such risky practices, however, equally the regulator had no idea what was going on either. Retail can do plenty wrong, however this is because it is allowed to take such risks. Investment based high risk underwriting activity should not be coupled with retail deposits, its that simple. Part of the driver for this is market expectation and ROE, if retail banks were expected to make returns of 6% vs 12-15% then the risk to conduct highly leveraged business would diminish. Bank executives bonuses are tied into return expectations, so of course they will move heaven and earth to make that money, and they did as we know, often in plain sight of the regulator, such as financial innovation as originate and distribute, securitisation etc. Retail banks need to be heavily regulated in this regard and prevented from conducting this business. The networked and homogenised banking system requires separation, and simplification - not as basel rules are doing, relying on a neoliberal agenda or overly scientised and complex rules, that frankly are going to become ever more complex to deal with these problems - that shadow banking system will be next to see regulation - Basel IV (the sequel). I agree completely, regulators struggle to keep up with quants in banks, and do not understand complex proprietary trading models that frankly MIT graduates are challenged with. The BoE still think bank models work through intermediation, not originate and distribute to avoid capital charges that Basel enforces on such risky lending - LBO's etc. Retail and Investment banking should be placed in silo's and not allowed to cross activity, an be regulated as separate divisions of banking with individual rule bases - and on an international basis if at all possible to disinter-mediate problems with bubbles, capital flows and associated crisis. Failure is indeed important, banks should be allowed to go bankrupt, equity holders reduced to zero value, BoE steps in with liquidity support whilst the bank is sold, and the central bank is repaid from sale proceeds - an orderly process must be allowed to occur. However, the contagion effect of risk within an homogenised and networked banking system allows equity to stay whole, albeit devalued, whilst the tax payer bails out - this so called moral hazard. The silo mentality may also help, at least to some extent, with the network effect of financial contagion we witnessed in 2008. Prevent the spread of disease as Andy Haldane has conceptualised it with network analysis and epidemiology. I appreciate the structure may not solve everything, and its not perfect, however simplifying the system has got to be the way to go versus increasing complexity. Simplify, re-structure, and regulate to reduce complexity and systemic risk - rather than playing around at the edges of the big issues with ring fencing depositors money with insurance and worrying about the regulators ability to carry out the job of keeping the financial system stable etc.

Frances Coppola


Companies are insolvent when 1) they cannot meet their obligations as they fall due 2) their liabilities exceed their assets. I agree that if they have no debt, the second of these is impossible. But the first is still possible. For example, they may not be able to pay wages: they may not be able to pay utility bills: they may not be able to pay rents on premises. Companies can, and do, go bust simply on running costs, and banks are no exception.

I agree it is unlikely that a bank's loans would be completely worthless, but if the value of the assets when realised is insufficient to meet current obligations, the bank is insolvent.

I can't comment on Positive Money's proposals, though it sounds as if they are using depositor haircuts to recapitalise failing banks, as was done in Cyprus - in which case deposits are in effect subordinated debt. But the principle of unsecured creditors taking losses in insolvency is well established, though we seem to have forgotten it in recent years. Depositors are unsecured creditors. If a bank is insolvent, they may not get their money back. That's what happens when you put your money at risk.


I don’t see how an entity (bank or any other entity) that is funded just by equity can fail. If the loans or investments made by such an entity become totally worthless, the entity is still not insolvent because it doesn’t owe any money to anyone.

Shareholders’s stakes become worthless, of course. But anyone is free to buy those worthless shares and see if they can get the business going again.

But in any case, it’s unheard of for a bank’s loans to become worthless. I looked at some figures for insolvent SMALL banks in the US recently, and the value of loans was nearly always worth more than 50% of face value. There was just one instance out of about 50 insolvent banks where the value of loans had dropped to 10% of face value.

In the case of the larger banks that we have in the UK for the most part (and that’s where the systemic danger lies) I would hope the above sort of 10% catastrophy is near impossible.

Re Positive Money and Kotlikoff, I definitely prefer Kotlikoff’s system. In fact Positive Money’s strikes me as plain illogical: that is, PM is prepared to let depositors take a hit when a bank fails, in which case depositors are in effect a type of shareholder or “loss absorber”. That being the case, I am baffled as to what the point of insolvency proceedings is.

For example, if what triggers insolvency under PM’s system is loans being worth less than 90% of deposits (and assuming the bank is funded just by depositors, to keep things simple) then depositors’ stake is worth 90p in the pound. In that case, why not just say to depositors (as per Kotlikoff’s system) “sorry, but your stake is now worth 90p in the pound. You can cash that in now, or keep hold of your stake in the hopes that things improve.”

I’ll contact PM and ask them what they’re on about.

Since the Govt was handed over to Press Secretaries and the tabloid editors the Govt has become about the production of rhetoric and butt covering. Thus the obsession is to pretend they did something and the best way to do that is laws and regulations and this is done regardless of Tory or Labour Salt Brand.

Prosecuting fraud and bringing in proper RICO/conspiracy laws or in the US case using them would cause a change in behaviour. Fraud other than by rubes is tricky and expensive. Nonetheless the legal equivalent of running a house of ill repute would mean even Dimon and Diamond suddenly cared where their profits were coming from.

The size of the banks is not necessarily the issue the size of the fraud is. Govt seems to want to endorse (by omission) the fraud and deal with things that do not matter or necessarily stop more fraud.

Bringing in rafts of red tape it is surely what the Tories claim wrong about the rest the business climate.

Frances Coppola


I wouldn't take that as "evidence", really. There is also the possibility that people are more likely to default on a mortgage from a bigger bank because they think the bank is big enough to take it. And without evidence of market concentration, where the banks were lending and to whom, I don't think that graph really proves anything.

There is zero evidence in the UK, though - and this was a UK conference. Small banks and building societies behaved just as badly as large ones.

You have misunderstood my point about how to make a bank 100% safe. A bank that lends AT ALL can go bust. Positive Money's solution (at-risk deposits funding risky lending) does not prevent insolvency. It prevents taxpayer bailout - which is not the same thing.

Kotlikoff is arguing for separation of deposit-taking from lending, so deposit-takers only invest in safe assets and lenders lend only from their own capital, so they don't put other people's money at risk.

Selgin's comment does not apply to banks that take deposits. Deposits are debt liabilities. And it is not really true anyway. A bank lending only from its own capital can fail, just as any other company can fail even if it has no debt. Debt increases balance sheet fragility and therefore raises the risk of failure, but eliminating debt does not eliminate the risk of failure.

It's worth remembering that shareholders' funds are "someone else's money" too - often people's pensions. They are not "free money" that can be treated in a cavalier fashion. Banks have a responsibility to their shareholders as well as their creditors. I think people often forget this.

The above article claims there is an “absence of any real evidence to support” the idea that big banks behave any worse than small ones. Actually there is some good evidence (scroll down to the chart) here:

Re putting a so called “ring-fence” between retail and investment banks, I agree the whole idea is very defective. Plus I agree that the whole bank regulation “industry” has got itself bogged down in so much complexity that it has made things worse rather than better. Or as Richard Fisher, president of the Dallas Fed put it on the subject of Dodd-Frank: “We contend that Dodd–Frank has not done enough to corral TBTF banks and that, on balance, the act has made things worse, not better.”

The second last paragraph of the above article assumes that because banks fulfil a “deposit taking only” role, that there for banks don’t lend. That is pure false logic: the fact that butchers engage in sausage making does not stop them selling pork pies.

In other words it is perfectly feasible, as suggested by Laurence Kotlikoff, Positive Money and others to have banks offer a 100% safe deposit taking role for those that want that service, while at the same time, have them offer loans.

But how do we ensure that when those loan risks don’t pay off that the economy as a whole is not damaged, or at least that it is damaged less than was the case in the recent crisis? Well it’s DESPERATELY SIMPLE: having the lending done by bank departments (or even better by entirely separate legal entities) which are funded PURELY by shareholders or quasi share-holders. Kotlikoff advocates the “entirely separate legal entity” solution, which I like.

That way, all that happens when lending department or “lending institution” makes silly loans is that the shares drop in value. There is no need for bail outs. No need for bankruptcy proceedings. No crises.

When BP made an almighty mess in the Gulf of Mexico, BP didn’t close down. It didn’t go bust. All that happened was that it’s shares dropped in value.

Or as George Selgin put it in his book “Theory of Free Banking”, “For a balance sheet without debt liabilities, insolvency is ruled out…”

Maybe nostalgia, but when there were many regional building societies ,dominating the mortgage market , the industry for home loans at least was more resilient and therefore a model for the future. Also regulation needs to get personal, making boards and code workers the target of punishment, as h&s infringements are.

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RT @NIESRorg: Britain’s stunted ‘recovery’ leaves us wishing for what might have been | Jonathan Portes via @guardian

RT @ShodanAlexM: Good post > MT @Frances_Coppola Text of my talk at Manchester Univ’s PCES yesterday: “The failure of macroeconomics” http:…