Last night the FT teamed up with the London Stock Exchange to discuss whether we need more, less or different regulation for financial markets. John Kay and Martin Wolf led the evening with their talks. Both were suprisingly cautious about what you can expect regulators to achieve in the fast moving global world of finance. Both were pessimistic, expecting we will end up with more regulation of a kind which will not make us safer in future.
John Kay reminded us that 236 people were employed in the USA to regulate Fannie Mae and Freddie Mac. Were their jobs really necessary? They were slow to realise the seriousness of the predicament these two large companies got into, and were unable to do anything against the lobbying power of the mortgage companies when they did think there was room for improvement. Despite the Regulators the companies got into financial trouble which required a huge Federal bail out.
Northern Rock was a heavily regulated business in the UK. Its business plan and accounts were permitted by the FSA. It took its regulatory duties very seriously. No-one suggests it bent the rules or tried to misinform the Regulator. Indeed, in the last Accounts before the crash the Dirctors were busily planning how to reduce the amount of capital they held for a given level of business in response to the relaxation of capital standards being pushed through by the world Regulators in Basel II! I was told by the Chancellor I was wrong to propose getting rid of the mortgage regulations the present UK government brought in, as that would be dangerous! In all the years when we did not have such specific mortgage regulation we had no run on a mortgage bank. Its enactment and enforcement did not save Northern, or prevent Northern and others lending money to people against high house prices on high multiples of earnings. So what was it for?
The Northern Rock saga should remind us that sometimes regulations preversely make things worse rather than better. If there had been no capital adequacy requirements laid down, Northern’s Directors may have been more cautious. Because standards are laid down, Directors are tempted to say “Let’s deliver the required standard” assuming that will be prudent.
John Kay gave us a more modest list of things regulators could do. They could concentrate on policing activities to try to prevent or intercept criminal activity within financial businesses – attempts to steal client money in one way or another. They could ensure a comprehensive deposit protection scheme. The Central Bank should concentrate on providing cash to the system – where it has a monopoly – against reasonable security from the banks. The rest should be left to the market.
I found his approach convincing. I liked its modesty of aim, and the practicality of the individual recommendations. If Northern depositors had known they would get their money back under a protection scheme there might not have been such a run on the bank. If Northern had been able to get more cash from the Bank of England against proper security to protect taxpayers, the bank would have found it easier to pay off those depositors who did want to get out.
Those who want more aggressive regulation have to answer some difficult questions. Let us take this area of mortgage regulation. What would the government have done if their new mortgage regulator had had real teeth in the boom phase? Would they have watched whilst person after person was told they could not borrow money because they were not rich enough? Would they have been happy to see a queue of disappointed mortgage applicants told they could not get a mortgage against the stated price of the house, but only against say 80% of the stated value? Yet that is the type of action the Mortgage Regulators would have to have taken a couple of years ago to prevent the negative equity and the repossessions of today. The regulator would have to be both wiser about the state of the cycle and more powerful than the banks making the loans. He or she would also need protection against judicial review and legal challenge, as they would effectively be running the mortgage banks for them.They would be preventing banks from lending money when they wanted to on the terms they wished to offer.
It simply is not practical in a fast moving global market to find regulators who are that good and to allow them to make all those calls. The 236 regulators of Fannie and Freddie and the Regulators of Northern could not have prevented the respective collapses. Employing more of them, or tightening the rules, will not prevent a future problem. All the time we have boom and bust Central banking and boom and bust government spending and deficits, there will cycles that are beyond the powers of the regulators to fix. So let’s this time stop the humbug about how we “have learned the lessons” and will put in “regulation to fix it”. As the two commentators implied last night, the authorities are unlikely to have learned the lessons. Indeed, they are sending exactly the opposite signal. The message going out on both sides of the Atlantic is that private sector banks can make money in good times by lending lots, and can let the public sector pick up the bills when things go wrong in the bad times.