26 March 2008

Telegraph: Financial crisis finger of blame points at City rules

Finding a more reliable system of regulation will take years, writes Edmund Conway. For beyond all the hubris in financial markets, beneath the burning embers of the sub-prime market, the forensic analysts are slowly discovering compelling evidence that, along with Alan Greenspan's unnecessarily low interest rates, it was regulations wot dunnit.

As the experts at the Bank of England and Financial Services Authority examine the scene, they have realised with dismay that those state-of-the-art financial rules they forced on the City have been partly responsible for causing this terribly expensive pile-up.

What is even more terrifying is that not only did these rules take decades to formulate and introduce, the policymakers must now bend and distort them crudely in order to find a way out of the malaise.

It is something worth bearing in mind today when you witness the heads of these two institutions taking what is expected to be a major slug of blame for the credit crisis and Northern Rock's collapse.

Standing at the very apex of Britain's financial system, Bank Governor Mervyn King and FSA chairman Sir Callum McCarthy face the even more miserable task of trying to clear up the mess.

They are likely to hint that the financial regulation system had serious shortcomings which need to be tackled soon if it is to enjoy a speedy recovery.

According to market experts there are two regulations in particular that have malfunctioned. The first is the Basel system of banking regulations, part of which stipulates that banks around the world must have a certain cushion of capital (such as shareholders' money or bondholders' debts) as well as deposits - since banks cannot survive on deposits alone.

The problem with this system is that, as banks have had to notch up their losses from the sub-prime disaster on their balance sheets, the Basel rules have meant that they have also been forced into raising extra capital - by persuading sovereign wealth funds to pump in cash, by cutting dividends or by issuing new shares.

As the financial crisis worsened, so did their balance sheets, causing something of a vicious cycle.

With banks struggling to shore up their balance sheets, the last thing they intend to do is to lend out extra money to businesses and consumers. This in turn threatens to make the credit crisis even more severe.

According to Prof Peter Spencer, economic adviser to the Ernst & Young Item Club, part of the problem is that national regulators such as the FSA ought to have warned the banks long before they approached the minimum Basel capital requirement limits.

"The bank regulators relied far too heavily on the rules," he says. "What we ought to have seen is a situation where banks would bend to the discretionary will of the regulators. If the regulator says they need to shore up their capital or liquidity, they will have to do so."

This might mean giving more power to the FSA - the very institution blamed by many for allowing the Northern Rock crisis to unfold in the way it did. But there is no other choice, Prof Spencer said.

"We just have to trust in their judgment, and trust that their judgment is better than the credit ratings agencies. The FSA must be told that they are being given a second chance and they have to get it right."

These rules, incidentally, were last year beefed up by Basel II, though far from solving this problem of pro-cyclicality (making the booms bigger and the busts deeper) it threatens to make it worse.

Basel II has gone hand-in-hand with the second problem: the mark-to-market rule, which requires financial institutions to value complex instruments such as sub-prime mortgages and derivatives at their current market value - not a nominal sum. T

his eminently sensible idea has had the unfortunate side-effect of causing asset prices to spiral even faster, pushing banks and funds towards insolvency about as fast as it takes a financial wizard to put together a spreadsheet.

According to Paul Craig Roberts, a former assistant secretary of the Treasury in the Reagan administration, the mark-to-market rule should be suspended, since it is causing havoc in financial markets and prices no longer reflect assets' true values.

"It is mindless to allow a 'reform' to cause a financial crisis, but that is what is happening," he says.

According to Prof Spencer: "We aren't going to be out of this mess for 18 months. This crisis goes from bad to worse."

The next task, which will take many years to perform, is to find a more reliable system of financial regulation.

There is already consensus that regulators need to monitor banks' liquidity more carefully, since a sudden lack of ready cash was one of the chief problems.

But the problem with rules-based systems like Basel is that they create a false sense of security for both regulators and financiers. This is what, in part, caused the recent crisis.

Radical suggestions in the mix include taking control of interest rates away from central banks or making banking completely unregulated.

The longer the crisis goes on, the more dramatic and painful the inevitable overhaul will be.

By Edmund Conway

© The Telegraph