In the swirl of the current debates about whether to deploy a fiscal stimulus or not – and if so, by how much – we must not lose sight of what lies at the heart of the world’s current tumultuous economic condition – the failure of global banking regulation. Governments around the world – including our own – have had to come to the banks’ aid. As a result, the public has taken a significant stake in the sector whose behaviour triggered the current difficulties. One of the strings that must be very firmly attached to this aid is that of the need for the banks, in future, to adhere to effective regulation. They will moan about it, but these entreaties should not be given too much consideration. The international banking system has been operating under a loose form of supervision largely shaped by bankers, for bankers. And we can now see where that got us. It cannot be allowed to continue.
The finger of blame can be firmly pointed at the Basel accords – the international system of banking supervision overseen by representatives from the central banks and regulatory authorities of the world’s leading economies. When the current crisis first erupted, the G20 announced that it would immediately begin work on revising these accords. Papers are due to be submitted to the G20 this spring for its meeting in London. But so great has been the failure of the Basel system, it is questionable whether ‘reform’ will be enough. It was widely accepted that the first Basel system failed. When the revised system, known as Basel II, was agreed in 2004 it was hailed by its authors as the framework that would ‘promote the adoption of stronger risk management practices in the banking industry’. It has only taken a short time to discover just how hollow that claim was. Basel II – still being implemented – was in effect dead on arrival. Efforts to resuscitate it would be futile.
The Basel system has fatal weaknesses. It is only ‘soft law’ – its rules are in no way legally binding. Furthermore, Basel says absolutely nothing about compliance – it is purely about supervision. The agreement does not even address the need to counter the threat of systemic risk. It concentrates almost entirely on the issue of capital requirements. It says very little about banking liquidity, leveraging, reputational issues, or the use of off-balance sheet activities. Yet it is these features that stand out as primary causes of the current crisis.
Throughout the decade of tortured negotiations that led up to the Basel II agreement, the banks insisted on – and got – internal risk basing as the founding principle of the system. This means that banks with complex risk-taking models can select their own capital adequacy levels from a range of options. It also means banks can use their own measures to determine the degree to which they are exposed to risk. It allows banks to allocate their own risk weighting to their assets, including those that are off balance sheet. It also allows banks to use their own estimate of the probability of one of their assets going into default. This, in other words, was a highway code written by boy racers.
One final fundamental weakness of the Basel system is that it depends for its implementation on more than 100 different national regulators. So what we in effect have is a global financial structure supervised by a balkanised system of regulation. This is, and always would be, an unequal struggle, and one in which the attempt to apply international standards was always going to come off worse. It has generally led to a race to the bottom in terms of in-country regulation, because regard for national competitive advantage has always trumped regulatory concerns. Governments have been understandably mesmerised by the glitter of the financial sector, and by its ability, in buoyant times, to drive growth and fill treasury coffers. But that has at the same time made any particular government too ready to believe the risk they might run if they attempted, alone, to rein in any particular forms of excessive or overly risky activity. Banks could always wave the threat of going offshore. For as long as capital flight seemed to threaten continued growth, the banks had a firm hold on an important piece of political leverage.
When the house of cards threatened to collapse, governments were caught by the opposite end of the same leverage, as the banks plausibly argued that they were too big to be allowed to fail. So they were, and that is why such massive public resource has been put into propping them up.
Now that the action has been taken, the question should be not how to amend the Basel system, but what to replace it with. What is urgently needed is regulation and supervision on the scale of that which we are seeking to regulate and supervise. That is where the critical imbalance has been all along, and it is that which must surely now be corrected. Just as the scale must become larger, so the content of regulation and supervision must become broader. It must go beyond the simple issue of capital adequacy – and move on to also cover issues of liquidity, leveraging, securitisation, off-balance sheet activity, accountancy standards and incentive structures. We will surely also need credible early warning devices.
While the banks are on their collective backfoot, the terms of trade for this business are firmly in the favour of the world’s leading governments – all of whom have expended huge economic and political capital in coming to the banks’ rescue. While that remains the case, governments need to move quickly to reach international agreement on what a new banking regulatory structure should look like, both in terms of content and enforcement. It is only in this current climate that concerns about national competition in financial services can be parked to one side. Now that it has been amply demonstrated that a major failure in the banking system affects all countries, and not just the one in which the problem originated, there must surely be scope to reach the necessary agreement and lay the foundations of the first ever truly international system of banking regulation and supervision.