The Future of Financial Regulation

The Future of Financial Regulation Howard Davies The last quarter of 2007 was a very good time not to be a financial regulator. And I suspect that the first quarter of 2008 will not be much easier. The turmoil in global financial markets, which as recently as last July was a cloud no bigger than a man’s hand, has spread from the wilder shores of the subprime mortgage business in trailer parks in central Florida, to the heart of the London interbank market. It is not surprising that US mortgage lenders, and the investment banks who securitised their loans and traded them extensively, have run into problems. But so have German and Geordie banks. What began as a house price correction transmuted into a general widening of spreads on risky assets, then a liquidity squeeze and now looks well on the way to becom- ing a full scale credit crunch. Martin Wolf, Chief Economics Commentator of the Financial Times, has talked of a “revulsion” in capital markets, as investors in all types of asset-backed securities have rushed to the exit. In the central banks it has been all hands to the pump to supply liquidity which the markets themselves are unwilling to provide. They came to the task with varying degrees of enthusiasm. Yet in spite of this massive assistance the crisis seems far from over, and looks highly likely to have a significant impact on the real economy, certainly in the United States, and probably in Europe as well. As a result, politicians and others have raised serious questions about the adequacy of market regulation. Could the crisis not have been pre- vented? Were the regulators asleep at the wheel?—a common cliché which is proudly trotted out by politicians at these times, as if freshly minted. Sir Howard Davies is Director of the London School of Economics and Political Science. The article is an edited version of the speech he gave at Oxford University on January 15, 2008 at a seminar organised by OXONIA, The Oxford Institute for Economic Policy. WORLD ECONOMICS • Vol. 9 • No. 1 • January–March 2008 11 Howard Davies In the regulatory bodies themselves, the loudest sound is that of stable doors being slammed shut. But there are also countless reviews under way, both domestically and internationally, to try to understand what went wrong and what might be done to strengthen our defences in the future. In this article I shall try to parse some of the so far rather inchoate criti- cisms of the performance of the regulatory system and to give a prelimi- nary assessment of where there is a case for a change. But first let me provide one simple conclusion from my new book with David Green, who was head of international affairs at the UK’s Financial Services Authority (FSA).1 The global regulatory system is rather complex. Figure 1 shows the heavily simplified version. It has grown up like topsy and committees have proliferated extravagantly. New committees rarely die. That is especially true in the European Union, where it is given to few to understand how things are supposed to work (Figure 2). There is a powerful case for simplification. (How this might be done is described in the book.) Figure 1: Global committee structure—a regulator’s view G-7 (Governments) IMF World Bank OECD (Governments) WTO (Governments) FATF (money laundering) IASB IASC Financial Stability Forum IAASB Monitoring Bank for (Audit) PIOB International Group Settlements (Central banks) G-10 Basel IOSCO IAIS IFIAR (Central banks) (Banking) (Securities) (Insurance) (Audit) CGFS CPSS Joint Forum Source: Adapted with permission from Sloan and Fitzpatrick in Chapter 13, The Structure of International Market Regulation, in Financial Markets and Exchanges Law, Oxford University Press, March 2007 1 Global Financial Regulation: The Essential Guide. Howard Davies and David Green. Polity Press, March 2008. 12 WORLD ECONOMICS • Vol. 9 • No. 1 • January–March 2008 W ORLD Figure 2: European committee structure E Council of Ministers (ECOFIN) FSC EFC European Parliament CONOMICS Financial Services Economic and Committee Financial Committee European Commission Council CoRePer Working Groups Ambassadors (legislative) • Vol. 9•No.1January–March 2008 • Vol. (legislative) Government level ESC ARC EIOPC EBC EFCC AURC (Finance Ministries European Accounting European Insurance European European Financial Audit and observers from Securities Regulatory and Occupational Banking Conglomerates Regulatory regulatory level) Committee Committee Pensions Committee Committee Committee Committee The FutureofFinancial Regulation Regulatory level CESR CEIOPS CEBS IWCFC EGAOB (Competent authorities) Committee of Committee of European Committee of Interim Working European Group European Securities Insurance and Occupational European Banking Committee on of Audit Supervisors Pension Supervisors Supervisors Financial Oversight Bodies Conglomerates 3L3 Committee Central Bank level Banking Supervision Outside Commission ECB Committee framework Committee of the ECB 13 Source: Adapted with permission from a chart originally devised by John Sloan Howard Davies A health warning Before I begin parsing, I should enter a health warning. It is always dangerous to devise regulatory policy in the midst of a crisis. As I have argued elsewhere, financial regulation in the UK, and indeed elsewhere, can best be explained as a series of Dangerous Dog Acts. Legislation is often con- ceived in haste in response to a particular example of excess. In the United States, the Sarbanes–Oxley Act is clearly in this category.2 It may well have some merits, but almost all observers would acknowledge its inflexibility and unintended consequences. It was certainly legislated in haste and American markets have now been repenting for a while. So it is quite important not to be seduced into new regulations and controls by market panic, controls which might in the long run be very costly and deliver insufficient benefits. But even with that health warning in mind, we must acknowledge that the last six months have raised some interesting and difficult questions for central banks and regulators, whether unified or separated. I identify seven, as follows: Question 1 is about the causes of the crisis. Did the Federal Reserve itself inflate the bubble by pushing interest rates down too far in the after- math of the collapse of the dot com boom and 9/11? Were other central banks accessories after the fact? Question 2 is, in some ways, more fundamental. Does this crisis show that liberalisation in financial markets has gone too far, and that there are fundamental flaws in what people, especially the French, call the Anglo- Saxon model? Question 3 relates to the origin of the crisis last summer in the US subprime mortgage market. Is there a fatal flaw in that market, which was pos- itively encouraged by the Ancien Régime in the Fed on the essentially political grounds that home ownership was thereby expanded? Question 4 relates to the Credit Ratings Agencies. Did they fall down on the job, and was their failure attributable to fundamental conflicts of interest in their business model which need to be corrected? 2 The Sarbanes–Oxley Act was passed in July 2002 and was a direct reaction by the US Congress to address the accounting scandals of 2001 and early 2002 including the Enron debacle. The Act’s stated purpose is “to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes”. 14 WORLD ECONOMICS • Vol. 9 • No. 1 • January–March 2008 The Future of Financial Regulation Question 5 relates to liquidity. Can we be happy that central banks have had to inject liquidity on such a massive scale? Do bank regulators need an entirely different approach to liquidity? Question 6 relates specifically to the UK: Does the Northern Rock problem demonstrate a fundamental flaw in the UK arrangements, whether in the Tripartite system itself or in the separation of banking supervision from the Bank of England? Question 7 relates to global financial regulation, the subject matter of my book with David Green. Does the response to the crisis show that there are gaps in the global regulatory system which need to be filled? Is there a leadership problem within the complex network I illustrated in Figure 1? I shall attempt to answer these seven questions in the remainder of this article. Q1. Did the Fed cause the problem? This is the one of my seven questions on which I am proposing to enter an open verdict. My excuse is that it is essentially a macroeconomic question, rather than an issue of financial regulation. It was almost universally acknowledged that the markets were awash with liquidity and that real interest rates were very low, indeed often neg- ative. So credit expanded extravagantly. Were central banks focused on the wrong indicators, fiddling while New York burned? In focusing exclu- sively on the use of interest rates to target inflation (and stabilize output) are we shifting volatility to other markets? The case for the prosecution has been trenchantly argued by Steve Roach of Morgan Stanley. In a piece in Fortune magazine unambiguously entitled “The Great Failure of Central Banking” he argues that “central banks have failed to provide a stable underpinning to world financial markets and to an increasingly asset dependent economy”.3 Roach maintains that “the current financial crisis is a wake up call for modern day central banking” and that “the art and science of central banking is in desperate need of a major overhaul”. His principal concrete recommendation is that monetary authorities need to take the state of asset markets into explicit 3 ‘The Great Failure of Central Banking,’ Stephen Roach. Fortune, August 2007. WORLD ECONOMICS • Vol. 9 • No. 1 • January–March 2008 15 Howard Davies consideration when framing policy options and that “failure to recognise the interplay between the state of asset markets and the real economy is an egregious error”.

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