Fifteen years ago the fashion in British financial circles used to be self-regulation by each segment of the market-insurers, building societies (mutuals), hedge funds, etc. Banks were meant to be regulated by the Bank of England. There was a Securities and Investment Board to regulate the stock markets. Then self-regulation went out of fashion. The Bank of England had some bank failures on its watch?BCCI, Barings (thanks to Nick Leeson), Johnson Matthey to name but three. So when New Labour came to power the structures were changed. Financial Services Authority (FSA) was set up to have a regulatory overview of all the segments of the financial industry, including banks.
The FSA was set up on the idea that the different segments were interconnected and hence needed a single regulator. The Bank of England was left with not much to do but a tripartite arrangement was formalised between the Bank, FSA and the Treasury with quarterly meetings. This experiment proved disastrous. It may be that the big meltdown in the financial markets in 2008-09 may have been impossible to prevent, no matter what arrangements were made. After all the US, the UK and the EU had different institutional arrangements and they all failed to spot the trouble.
Still each country is reforming its own system in its own way. The UK with a new coalition government has just announced its own rearranging of the regulatory furniture. The Bank of England will be in charge of macro-prudential supervision. The FSA is to be chopped up. Its bank supervisory staff will be put under the Bank of England as a Prudential Regulatory Authority (PRA), with the CEO of FSA transferred to the Bank of England as deputy governor in charge of PRA. This is the micro-prudential function. The parts of the FSA that looked after consumers? protection and consumer education will be hived off in separate parts.
This legoland exercise apart, there is still a debate to be had on what sort of banking we need. The US is debating the issue of large versus small banks, Glass-Steagle a la Volcker and the toxic swaps, which excite fear and loathing in the context of a large bill going through Congress. The UK has just had a report on banking reform from a commission appointed by the private consumer watchdog Which? magazine. The government, in turn, has now appointed an official commission to report on banking structures to validate or improve upon the Which? report. Here again, large versus small banks, universal versus single purpose banks will be debated.
There is, therefore, now a lot of uncertainty in the financial markets as to what the future of banking is to be and how the new structures will work. The government will need to legislate to break up the FSA and assign new powers to the Bank of England. By the time it has done this, the report of its newly appointed commission will be in. Then again, there will need to be new legislation. All this may take at least two years.
It is not clear to me that it is structures that caused the problem rather than behaviour. This is because different types of regulatory institutions, on the two sides of the Atlantic, did not make much difference. Canada has managed to escape the meltdown because it has a much more conservative banking industry. Sweden went through a bloodbath in the early 1990s and reformed its banking and so escaped the meltdown this time. The issue is risk-taking behaviour and the incentives offered for excessive risk taking. The trigger was the availability of cheap credit, thanks to over-saving by Asian economies, which was lent to the OECD nations. For their part, the OECD governments were overspending and borrowing the money from the Chinese. They also encouraged households to incur debt. Cheap credit lowered the cost of risk taking on part of bank lenders and other financial agents. The causal sequence has been the same in every financial crisis for the last 200 years?cheap credit, excessive risk taking, bad loans, asset bubbles, bust. The only things we have changed are the financial innovations that each generation has been seduced by into thinking that ?this time it is different.? (To echo the title of the excellent book by Rogoff and Reinhart.)
So we wait to see if this new structure will solve the problem of financial crises. I doubt it, but at least there is a debate on the appropriate role of banks in modern economies. Macroeconomics has avoided integrating banking into its theories and now we know the cost. We may also begin to fashion research on how different cultures of banking lead to different susceptibilities to contagion and crisis. Who knows? Maybe our knowledge will be better the next time around.
?The author is a prominent economist and Labour peer
