2.01  Even though other chapters in this book set out the broad lines of reform proposed for regulatory systems, especially in Europe, it is still very difficult to produce a clear assessment of the likely consequences and effectiveness of the reform programmes. That is true in the case of the global changes, and also in respect of individual countries.

2.02  The first reason for this difficulty is that there remain many ‘moving parts’. The G20 have set out some clear directions for change, which have been articulated through the FSB. The Basel Committee has also produced, in a more than usually timely manner, a set of recommendations (Basel III) to strengthen the capital backing of international banks. But the implementation of those proposals clearly varies from country to country, and there are major differences between the regulators and the banks at present about the quantum of capital which should be required, and especially about the appropriate timing of increases. The United States moved more quickly. EU regulators were somewhat slower, and in view of the continuing Eurozone crisis there is a fear that EU banks will improve their ratios more by reducing lending than by raising new capital.

2.03  In the United States, the Dodd-Frank Act has been passed. But there remain many uncertainties about the impact of the legislation, since the Act gives much discretionary authority to regulators. Also, following the mid-term elections, Republicans in Congress, who were opposed to many parts of the Act, have pledged to look closely at its potential impact on jobs. We cannot easily forecast, for example, how the so-called Volcker rule will be interpreted. In principle, the rule prevents banks with access to the Federal Reserve, and insured deposits, from engaging in proprietary trading, but the impact of that decision depends heavily on the (p. 49) definition of proprietary trading which regulators choose to adopt. That remains highly controversial.

2.04  In Europe, as Eddy Wymeersch¹ explains, relatively rapid progress has been made in reforming the architecture of supervision at European level. But it remains evident that the European Council, the Parliament and the Commission have different views about how the new structure should work in practice. Within the Council itself different Member States also have different ambitions about the extent to which the new European authorities should be able to impose themselves on national regulators. The United Kingdom, in particular, is resistant to any further transfer of authority to pan-European regulators, even though that is clearly implied by the post de Larosière structure. At the European summit in December 2011, Prime Minister David Cameron tabled a list of demands, related to financial regulation, which were his conditions for accepting a new treaty. Those demands were rejected, but the issues he raised will undoubtedly reappear.

2.05  In individual countries, too, there are still many uncertainties. In the United Kingdom, the coalition government elected in May 2010 has embarked on another structural reform of financial regulation. The FSA will be divided in two with a new Financial Conduct Authority and a Prudential Regulatory Authority as a subsidiary of the Bank of England. Over the two will be a new Financial Policy Committee, which is already operating in shadow form. The legislation implementing these changes will not be passed until late in 2013, but the new ‘twin peaks’ structure will be put in place internally in April 2012. However, while the new structure is now clear, we do not know how differently the two authorities will operate in practice. Structure is one thing, regulatory practice is something else.

2.06  There is another, perhaps more important, reason why an assessment of the reforms is problematic. There is still no consensus available about precisely what went wrong in financial markets which generated the crisis through which we have been living. Usually, when a natural or man-made disaster strikes the world we begin with a range of different, sometimes speculative, sometimes quite far-fetched explanations, and then gradually, as the evidence comes in, a central view becomes clear. In the case of the financial crisis, almost the opposite is true. There is still no consensus on what the most important factors leading to the crisis were. How far were global imbalances and the so-called savings glut to blame? Was this essentially a failure of monetary policy, or of regulation? Or were firms themselves out of control?

(p. 50) 2.07  As a kind of intellectual exercise I have listed the number of explanations currently in the market, so to speak. I found 38 of them worthy of consideration, which I have set out in a short book.² My primary aim in that book was not to offer my own patent solution, but rather to explore the pros and cons of different explanations, and what one needs to believe in order to support particular propositions. But I do point out that some of the remedies currently on offer from politicians seem to be solutions in search of a problem. In my view that is true, for example, of bans on short selling. The case against short selling has produced some unlikely bedfellows. Jimmy Cayne, the former Chairman of Bear Stearns, has argued strongly that short-sellers destroyed his firm. Angela Merkel adopts the same view in relation to Eurozone bonds. It is highly unlikely that they share common views on anything else.

2.08  So before proposing an assessment of the reforms, one needs to set out at least briefly the criteria one is using to determine their effectiveness. My principal test is this: are they well designed to respond to the factors most important in the build-up to the crisis? But that question presupposes a view on which of those factors were central to the crisis.

2.09  My own assessment of the primary causes of the meltdown would put global imbalances at the beginning of the argument. Large flows of liquidity from surplus countries into the United States and other markets in search of low-risk assets yielding more than Treasury bills caused risk to be mispriced, and increased the incentives for the market to manufacture synthetic low-risk assets. There was a powerful appetite for securitizations, which the ratings agencies were prepared to deem to be of AAA quality. Asset prices rose sharply and credit, both inside and outside the banking system, grew very rapidly. Monetary policy, which was single-mindedly focused on low retail price inflation, did not respond effectively. The prevailing central bank orthodoxy was that the best central banks could do in these circumstances is to mop up after the event, and that ‘leaning against the wind’ is doomed to failure. That now looks to have been a major mistake.

2.10  When the crisis hit, we also discovered flaws in the regulatory regime. In retrospect, we can see that banks were operating with capital backing which was too low to cope with high volatility and the impact on asset prices of a sharp decline in GDP. Furthermore, much of the capital they held was of poor quality, in the form of hybrid convertible instruments which did not provide adequate support when needed. Regulators had also stood by while arbitrage opportunities were exploited, creating a massive expansion of off balance sheet credit. At the same time, financial innovation generated complex products, which came to the market armed with misleading ratings. Financial innovation had run well ahead of the capabilities of firms’ risk management.

2.11  If that broad diagnosis is correct, then much of the activity in regulation looks to be irrelevant, at best, and falsely reassuring at worst.

2.12  The proposed reforms to regulatory structure in a number of countries are a case in point. As David Green³ points out in his chapter, we can draw no very obvious conclusions from the relative performance of different regulatory systems in the crisis. The regulatory structures of the United Kingdom and of the United States could hardly be more different. The UK system was highly integrated, the US system was highly compartmentalized, yet both performed rather poorly, at least in the build up to the crisis. If we look also at the countries, which seem to perform relatively well, like Australia, Canada, and perhaps Spain, no clear pattern emerges either. There is no convenient correlation between success and any particular structure, nor is it possible to say that central banks as regulators have done systematically better or worse than non-central banks. The Bank of Spain has been praised by those who support a strong role for the central bank in regulation for its introduction of dynamic provisioning (though less so as the problems of the Spanish banking sector have become better understood), but in both Australia and Canada the central banks have no direct involvement in banking supervision, and the non-central bank regulators have done very well.

2.13  There are a few tentative conclusions one might draw, however. The complex interactions between different types of financial institutions, which were revealed during the crisis, are a further argument for some form of regulatory integration. The case of AIG, for example, an insurance company that came to grief through its dealings in securities markets with banks, vividly illustrates the need to take an overview of market trends to understand emerging systemic risk. Specific problems of underlap and overlap have been identified from place to place. That is particularly true in the United States, where the regulatory system is surely still over-complex.

2.14  In Europe, the Icelandic banking crisis revealed a major flaw in the operation of the single financial market. Icelandic banks regulated by their own domestic authorities were able, under the provisions of the single financial market, to take deposits in the Netherlands and United Kingdom, without oversight from the host regulators. Yet the domestic Icelandic authorities were unable to provide the backing needed for their banks when massive losses, largely in property-related lending, were exposed. So it has been necessary to revisit the home-host regulatory relationship and to explore other options for the regulation of pan-European institutions

(p. 52) 2.15  In the United Kingdom, the main conclusions seem to be that there were poor communications and somewhat dysfunctional relationships between the Bank of England and the FSA, and a Treasury which seemed not to be capable of knocking heads together within the context of the tripartite arrangements. Whether that justifies a major reworking of the institutional structure is less clear.

2.16  At global level the conclusion reached by the G20 is that the central bodies were too weak, and had the wrong membership. Arguably, the link between the membership structure of the Basel Committee and the FSF (as it then was) and the causes of the crisis is a little loose, but it is not negligible, and the argument for shifting away from the G7 to a broader grouping has been powerful for some time. While central banks and regulators watched the build up of global imbalances, the major firms in which they came together did not include any representatives of many of the biggest surplus countries, notably China. So some of these reforms, while unlikely to prevent future problems, may make sense in their own terms, and should perhaps be considered under the general heading of: ‘it is important never to waste a good crisis’.

2.17  But while recognizing that the crisis has stimulated sensible changes which should have been made some time ago, even if a path cannot be easily tracked back from them to the flaws which led to our problems, it surely vital to ask whether we think that the reforms so far have made the financial world a safer place, and whether they amount to an effective response to the problems identified?

2.18  Against that background, the initial global response was quite positive. The switch to the G20 was probably inevitable. Arguably, the G20 is too large a group, just as the G7 was too small. It might have been preferable to construct a group for financial oversight comprised of countries with very large international markets in their jurisdiction. That would point to the membership of Singapore, for example, but not Argentina. However, the time for that argument has now passed. There are very few examples of countries being relegated from positions of influence in international groupings once they have been admitted. So the G20 must be made to work.

2.19  I am also in favour of the change from the FSF to the FSB. David Green and I recommended a change along those lines in our book on global financial regulation.⁴ Of course, it may be argued that renaming a body does not, in itself, give it greater powers. But the fact that the G20 ministers now look to the FSB to coordinate regulatory changes is positive. The Cannes summit in November 2011 agreed that the FSB needed a legal personality and stronger staff support. That is also positive. So there is now a much more effective accountability mechanism for groups like the Basel Committee and IOSCO. It will not to be possible in future for Basel to (p. 53) spend a decade producing a capital accord, as it did in developing Basel II. Indeed, the outline of a new Basel III has been produced very rapidly, partly because the FSB demanded rapid progress. The FSB has set out a broadly sensible agenda, focusing first and foremost on reforms to the capital regime, which do look to be essential to improve the stability of the system in the longer term.

2.20  The new capital accord is absolutely central to the reform programme. It is clear that banks need more capital than they held in the past, especially in their trading books, and they need that capital to be of better quality. In other words, they need a larger proportion of common equity capital in the total. Broadly, the banks themselves accept that conclusion, but they are currently concerned that the aggregate of the changes under Basel III could amount to overkill. It may be that regulators are beginning to demand more capital from banks than they could reasonably take on, and to do so in a way which effectively will increase the cost of credit to borrowers and, in turn, slow down the recovery.

2.21  The regulators are well aware of these concerns, and of the risk of tightening their requirements at a time when capital is scarce and credit is in short supply. Though the regulators are still talking tough, I suspect they will be prepared to envisage longer phasing in of new requirements over time. There is a need, too, for some rationalization of the various different ‘buffers’ in Basel III.

2.22  The work on cross-border resolution, which the Lehman Brothers collapse showed to be especially important, is moving more slowly. The legal complexities of cross-border bankruptcies are immense. It may be that progress made already towards establishing domestic resolution authorities will be helpful, but although the FSB has now made some constructive proposals there is a distance to go before we can say that we have a global resolution mechanism which matches the interconnectedness of markets. Without that, there will certainly be a tendency for regulators to seek to ring-fence capital within their jurisdictions to protect the domestic counterparties of a failing firm.

2.23  While this work is moving forward, there are also many signs that individual countries are responding to domestic political imperatives, implementing changes of their own which may sometimes not be compatible with global accords, and which may make some of the cross-border issues more complex to resolve, and also create opportunities for regulatory arbitrage, which we would hope to prevent.

2.24  That tendency is very obvious in the United States, where there are proposals on derivatives trading which have not been enacted elsewhere and are unlikely to be so. The Volcker rule is unlikely to be copied in Europe. In London the Vickers report has proposed a different set of constraints which will effectively split up the (p. 54) major banking groups. The United Kingdom also went its own way on the taxation of bankers’ bonuses and the FSA has introduced a new liquidity regime of its own which they did not seek to syndicate internationally. There are different approaches being taken in different countries to the fraught question of macro prudential supervision.⁵ The Swiss have introduced a leverage ratio as a ‘belt and braces’ addition to the global capital rules.

2.25  It is not possible, in a short chapter, to produce an assessment of effectiveness of the individual country responses, especially where the market dynamics are quite uncertain. But I would offer a few comments on what has been proposed so far.

2.26  In the United States, what is quite striking is that the diagnosis of the problems of the US regulatory system which was put forward by Hank Paulson, when Treasury Secretary in March 2008, barely featured in the Congressional debates of 2010. The 2008 Treasury paper⁶ was a very clear analysis of the weaknesses of US regulation. It proposed, for examp1e, that there should be a new optional Federal Charter for insurers overseen by a federal insurance regulator. The United States is currently the only country without a national insurance regulator. The paper also pointed to the dysfunctional overlaps between the Securities and Exchanges Commission and the Commodity Futures Trading Commission and argued the case for a merger of those two commissions. It also set out the argument for a single prudential regulator for banks to avoid the possibilities of regulatory arbitrage. None of these proposals have been legislated. The entrenched interests of the regulatory institutions themselves, and of ‘their’ Congressional committees, have made progress impossible, even in these difficult conditions.

2.27  So while there are good things in the US reforms (I would point, particularly, to the legislation to force more derivatives contracts onto exchanges, which will have an impact on the ‘complexity’ problem which I see as one of the key elements of the crisis), there are many other aspects of the legislation which do not seem very closely related to the reasons for the crisis. The Volcker rule may have some logic on its side, but it is not clear that the kind of proprietary trading and hedge fund activity which investment banks would be prevented from undertaking in the future was in fact a significant part of the problem. I also tend to the view that this provision, on its own, may well shift systemic risk outside the regulatory sector. Hedge fund and private equity funds are likely to grow even larger, as investment banks will be prohibited from competing with them. Yet there are no proposals to bring them within the regulatory net. As Randy Kroszner has argued,⁷ this may have the adverse effect of shifting systemic risk further away from regulatory oversight.

2.28  In the EU Jacques de Larosière was asked to analyse the problems and propose solutions. His report was a brave attempt to reform European regulation within the tight constraint of an inability to propose Treaty change.⁸ He recommended the establishment of a European Systemic Risk Board, chaired by the President of the European Central Bank, which is undoubtedly a step forward. And he also argued for the introduction of three new authorities. They are described, together with their means of operating, by Eddy Wymeersch.⁹ But the continuing turmoil in the Eurozone, and the worries about pan-European banks, have continued to raise questions about whether the de Larosière reforms are adequate—even before they have been implemented. My own view is that the doubters have a point. I suspect that there will be a need for some kind of a resolution fund, at least within the Eurozone, to rescue institutions in difficulty. A clear proposal for such a fund has been put forward by William Buiter, formerly of the LSE and now Chief Economist of Citigroup.¹⁰ The continuing turmoil in the Eurozone over the summer and autumn of 2010 has convinced many of the need for structural change.

2.29  I also suspect that the powers which the new authorities will have may turn out not to be sufficiently strong in any future turbulence. The mechanisms for mediation between regulators are untried, and will be difficult to implement, especially against the background of political resistance, notably in the United Kingdom, to more centralization of regulatory control. I therefore find it hard to conclude that these changes are the end of the story. There will continue to be pressure for some kind of pan-European regulator to handle pan-European firms, with access to taxpayers’ funds through some kind of resolution authority. It may be that the continuing crisis in the Eurozone 2010 will create, in due course, more favourable political conditions for fundamental reforms. In the meantime, we can best regard the EU process as unfinished business.

2.30  In the United Kingdom, the new regulatory system will take time to settle. Arguably, this is not a good time for an overhaul. Most important, however, will be the approach the Bank of England takes to its new role. We cannot yet know how the Bank of England will behave, but with its new statutory objective to maintain financial stability there is a reasonable prospect that the judgments on monetary policy will in future be somewhat more pre-emptive in relation to emerging financial imbalances than they were in the past.

2.31  So if we look back at the causes of the crisis, the assessment we might make of the reforms so far agreed, and in prospect, is inevitably one of light and shade. At the (p. 56) global level, while there has been a useful reform which brings countries like China into the management of the international financial system, there are few signs that the global imbalances problem is on the way to resolution. As in the case of the Federal Reserve at least, the resistance to a more proactive role from monetary policy in relation to financial stability remains quite strong. Chairman Bernanke has not been disposed to accept that the Federal Reserve made any monetary policy errors as in the early years of this century, which may have accentuated the build up of leverage. In the case of the European Central Bank (ECB), there is perhaps somewhat more recognition of the broader role of the central bank through the second ‘monetary’ pillar, but it is still too early to say how that will operate in the future. The ECB, along with other central banks, continues to be engaged in fire-fighting. Meanwhile, back on the regulatory front, the United States has once again missed an opportunity to rationalize its system, a failing for which I believe it will pay a price in due course. In Europe there remains a need to grasp the full implications of the single financial market, and of the Eurozone crisis, for regulatory structure. There again, we see much unfinished business.