I recall in the early years of the crisis, being invited to attend an informal meeting in Washington of the Financial Stability Forum of international regulators where a very senior US official explained that the problem in the US was that there was too much regulatory overlap. The US central bank, the Federal Reserve, regulated institutions that were also regulated by the Securities and Exchange Commission (SEC) and then there were the fifty insurance regulators who were increasingly regulating bank-like institutions that the Fed
and SEC probably should also have regulated. The official said they were going to swing into action with the biggest institutional reorganisation of regulation since the 1930s, with the expressed goal of making the US system more streamlined as in the UK. Which is odd really. Those of us with UK experience were just about to say at the meeting that the problem in the UK was caused by not sufficient regulatory overlap between the central bank and the regulator and that the UK should reorganise the British system to look more like the US.
When the Bank of England was made independent in 1997, some unfairly say this was the first and last bold move by the Labour Government, the Bank was shorn of its regulatory role and the Financial Services Authority (FSA) was set up
as a unitary regulator. The thinking was that this would preserve the Bank?s independence and focus on monetary stability. The Bank had been previously distracted, for over a decade, by the politically bruising repercussions of its decision to close down BCCI, a Pakistan-based bank that had attracted a number of ethnic minority clients with higher than average interest rates, which covered up lower than average standards. Monetary policy is different from bank supervision and so this separation of skills appeared to make sense at the time. Moreover, the Bank would still have responsibility for systemically important issues. It was all very neat. And it failed.
The Bank of England became an intense, quasi-academic, macro-economic research department, increasingly filled with young economists who knew little about banking and cared even less. FSA supervisors on the other hand were so pleased to be rid of the supercilious economists that used to breathe down their necks at the Bank that they did not realise that they were being pushed into an overly legal approach to supervision by threats from the large banks that they would
sue for unfair treatment. Bank supervisors went in to Northern Rock six months before it collapsed and noted nothing wrong with the fact that it made mortgages to the value of 120% of the value of the home and funded these mortgages with overseas money market funds. This may have been bad banking, but others did it, and the lawyers didn?t really know or care, as long as Northern Rock was legally complying with the rules. And when Northern Rock knocked on the door of the Bank of England for help, the young men at the Bank were
startled. Many of them had never heard of Britain?s fourth biggest mortgage lender?unless they were Newcastle United supporters (one of whom, oddly enough, the Bank of England Governor is).
Separating the FSA from the Bank brought with it many unforeseen problems. The opposition Conservatives in the UK have pounced on this failure of Prime Minister Brown?s tripartite system of the Bank, FSA and joint Committees of the two with the UK Treasury. They have threatened to scrap the whole thing, effectively abolish the FSA and give all power back to the Bank of England. Similarly, those who do not like the Reserve Bank of India are keen for it to give up its regulatory functions to others.
But one should be careful about drawing global lessons from local mistakes or getting sucked into issues that are political when they should not be. The best remark I have
heard on this subject came from the new (and perhaps last) Chairman of the UK, FSA, Adair Turner. While accepting that the FSA had made many mistakes, conveniently before he arrived, Lord Turner noted that regulatory failure around the world appeared to be indiscriminate to regulatory structure. The American system of overlapping regulators failed, but so did the UK system of clearly separated powers. The Canadian system, which resembles the UK system, appears to have succeeded. The real lesson to draw is that regulatory structure is not as important as it may appear to be.
That said, I think if you could start with a clean piece of paper, the evidence of this crisis is tilted towards less separation of regulation from central banks, not more. There are essentially three reasons. The obvious reason is that when the banks get into trouble in troubled waters, the only person who can offer them a life boat is the central bank. In which case it is probably better if the bank was involved with the patient before it is told it only has a few seconds to save it from a highly contagious death. Incidentally, one of the lessons of central bank support for stricken institutions is that even when regulation is separate from monetary policy, the exercise of the lender of last resort means that the central bank still gets embroiled in political issues. Should Northern Rock be saved? Is it big enough? Does it matter that Newcastle votes for the Governing party? The sought after independence turned out to be illusory.
The second reason why central banks need to be more involved in bank regulation is that financial crises do not occur randomly. They always follow booms. Any policy that addresses the crises must address the booms. But booms are the business of central banks. Which is not to say that central banks have the instruments to deal with a boom, or know all the answers, but that booms are macro phenomena. Consequently, the central bank is best placed to identify and measure them. The third reason is that despite the enormous growth of the shadow banking system in the world of finance, the rise of hedge funds and private equity funds, it was the banks who were central to this crisis. One of the lessons of this crisis is that the banks play a critical role in the supply of leverage that feeds the boom-bust cycle. Hedge funds use leverage; but they get it from the banks. This is because the banks are able to access the central bank?s liquidity window whenever they need to and others know they can. To be fair, while these are arguments for the central bank playing a more active role in guiding macro-prudential regulation, the instruments of that regulation are micro: bank capital adequacy requirements, leverage ratios, and liquidity buffers. Once set into a tightening or relaxing mode by the central bank, these instruments are probably best administered, sensitively and locally, by bank supervisors. Regulators need to be more concerned about macro-economic trends and the macro-economists at the central bank need to be more aware of banking developments. The person tilting the rudder and the person on the lookout need not be the same person, but they do need to speak to each other. Regulation failed because we got the obvious things wrong. Banks lent too much. It would be wrong to get too hung up over institutional structure and complexity. It doesn?t really matter how you rearrange the deck chairs on the Titanic if you are still heading for the iceberg.
The author is chairman of Intelligence Capital Ltd, emeritus professor of Gresham College and member of the UN Commission of Experts on International Financial Reform