All entries for Sunday 14 December 2008

December 14, 2008

Banks and Regulation

One of things that has stood out to me recently, is the propensity of members of the public to trust government regulation as a universal panacea for the ills of the banking system. The argument, as I understand it, goes as follows:

1. Industrial Leaders cannot be trusted to make sound judgement because they have a perverse economic self interest for short term gain.
2. Regulators don’t have that self interest and can thus make sound judgements in the public interest.
3. Consequently we should trust regulators and government over Industrial Leaders to do, ‘the right thing’.

I am inclined to believe in (1). There is an excellent case made in The Roaring Nineties that observes the combining of accounting and consulting firms as generating an economic incentive to not audit firms properly. This was a lesson that was perhaps more in the front of people’s minds at the time, soon after the Enron and Worldcom accounting scandal – but it is a problem that continues to face us now. Hopefully the IFRS clears up some of the issues involved.

Banks have a peculiar financial incentive to make risky investments. The government is obliged to bail them out in times of financial hardship. This is very obvious in terms of the so called nationalisation of the banking industry that has recently happened, but it is important to not ignore the Savings and Loans Crisis . Here the problem couldn’t be blame on complicated financial instruments (the bane of any regulatory authority is that they don’t control them) – but was mainly organisations being unable to appreciate that if they don’t have sufficient assets to back the loans that they are giving out and some of them go bad they are in trouble. Again, recent market deregulation, in this case the Depository Institutions Deregulation and Monetary Control Act acted as an enabler to systemically poor judgement on the behalf of those lending out money.

Its not hugely surprising that some of these companies are instinctively risk loving when you look at their history. Bank of America famously expanded in aftermath of the 1906 San Francisco Earthquake by loaning money to people on trust and without proper knowledge of their financial histories. The bank’s founder, Amadeo Giannini, was the only serious bank in town at the time, since he had taken the personal risk of death in order to get the bank’s gold deposits out of San Francisco during the earthquake.

I have more of an issue with statement (2) however. It is frequently the case that supposedly independant regulators are either controlled by former industrial leaders – people who they have been regulating, or their independence is undermined by lobbyists. In 2004 The US Securities and Exchange commission increased the debt to capital ratio for banks from 12:1 to 30:1. Its chair at the time was William H. Donaldson – a former chair of the New York Stock Exchange.

Henry Paulson, current US Treasury Secretary, at first requested congress allow him to personally distribute the $700 billion, with the guarantee that there was no way he could be criminally charged in relation to its distribution. In other words he was requesting to be able to give tax payers money to his friends and not be held responsible to any standards of oversight. As the former Chairman and CEO of Goldman Sachs he is another industrial leader who is unable to recommend policy with an objective eye.

The US Congress should, in theory, be an independent oversight on the actions of such people, but it is estimated that the banking industry spent $30 million on lobbying in order to pass the Gramm-Leach-Bliley Act in 1999. Some of this legislation increased competition in the banking market, however, the spate of mergers that resulted certainly decreased competition, and increased the recent contagion within the financial markets.

I am thus left asking myself several questions. Why should we trust a regulator if they are intimately linked with organisations that they are meant to be regulating? How can government be made truely accountable in the presence of well funded lobbyists and pervasive public ignorance? Is it possible to institute legislation that prevents systemic bad judgement?


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