The limits to regulation and the contradiction in the nature of banks

To counter the turmoil, we seek regulatory means to soothe markets and inhibit them from the excesses lately revealed. Yet, two critical factors have received little attention: the limitations of regulation and the essential (and I do mean "essential") contradiction in the nature of banks.

The first can be illustrated by Henry Paulson's recently recycled suggestions (FT, 18 March) to improve regulation of financial markets: basically, a proposal to control risk. The markets have failed dramatically on this, but apparently regulators can take us on the next step of humanity's evolution. If only the regulatory structure were bigger, more encompassing, better coordinated, with greater powers and superior analysis of information then.... This is a mirror image of what, until recently, commercial institutions were pursuing on their part. Having discovered market failure, Mr Paulson overlooks government and regulatory failure.

Brunnermeier et al have argued in The Fundamental Principles of Financial Regulation (2009) that the macro effects of systemic weakness are different from the micro effects of individual banks' problems. In seeking to exernalise risk for themselves, banks can build up systemic risk. This may appear to support the idea of clever systemic risk management tools. But, just as with the well known externalities of pollution, the simplest approach is always preferable: tough patrol of clear rules applying to the individual.

From my own experience in regulation of financial markets, sophisticated schemes whither in the heat of the market place. They are cumbersome in dealing with ruthless practitioners. (One might compare to the experience of the British government in dealing with the retirement package of the CE of RBoS or the various bonus fiascos in the U.S.)

A simple approach proposed by former British Chancellor Nigel Lawson is a return to Glass-Steagall: separating basic deposit taking from higher level financial activities. Even here the regulator would need to be robust in patrolling the border. Low risk institutions will be drawn to higher risk activities in seeking greater profitability than available through "plain vanilla" activities. High risk institutions will be drawn to low risk money as a cheap source of funds. But the simpler the border and the higher the fences, the easier to patrol.

This brings me to the second factor which tends to get overlooked - the nature of banks. Banks are both holders of other people's money and through, fractional banking, the key agents in increasing the supply of money and its velocity of circulation. Hence, we want banks to be prudent and, indeed, conservative, institutions. This is the image of the traditional stone bank building with Corinthian columns and marble halls. This is the image of institutions that do not fail, thus allowing depositors and central bankers to sleep at night.

As allocators of capital, and thus change drivers in the modern economy, and as businesses like any other, we need financial institutions to be flexible risk takers who experience the consequences of bad decisions and can go bust. Schumpeter famously wrote about the creative destruction of the market place and that is what we are seeing now. Those who over-reach – such as Lehmans – are destroyed. Giants who are sluggish and poor at assessing risk and innovation – and Citibank’s share performance has been weak for the past decade – die.

The balance may be difficult to strike but this doesn't mean we stop trying. But the complex and far reaching regulation now being pursued will tend to crush that balance.

We need innovation, dynamism and risk taking in financial markets. We can look to have a relatively safe end of the pool with retail banks but this does not mean there should not be a relatively risky end. The regulator’s role is to try and ring fence the safe end – which has not been much done of late – rather than try to spin rules to catch all. And the regulation of the safe end should be for national not pan-national bodies. This allows variety and experiment and – yes – failure.

Sensible international regulation is difficult to achieve. As anybody who has been involved in international negotiations knows, such a committee may aim to design a race horse, but will produce a camel. The idea of an international framework to govern financial institutions may sound attractive but realizing it will be fraught and the results disappointing. Think of Basle I and II.

Third, government entanglement in financial markets is dangerous. The more complex and far reaching the regulation, the more government(s) are embroiled in that which is regulated. That unleashes all the domestic and international political forces concerned. Fannie Mae and Freddie Mac were promoted as vehicles that could provide a stabilizing solution to the Savings and Loans crisis. Instead, they became immense de-stabilizers of financial markets as they sought to meet political goals.
We have seen the failure of a model which combined minimal regulation, poor enforcement, the two Basle accords with their evident gaps, the U.S. government sponsored Fannie Mae and Freddie Mac pumping out poor quality loans, and the Greenspan “put” on monetary policy. This does not tell us that tight regulation and enforcement, combined with government support and hence direction of banks, will restore the financial sector to health. In seeking to promote safety, such an approach will only provide the illusion of safety. It will prevent the resuscitation of a healthy banking sector and preserve the failed zombie banks provided they play by the rules. Capital will be inefficiently allocated, locking in poor economic growth and thus (without inflation) high levels of debt.