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Western EuropeApril 6 2008

Pressure for a knee-jerk reaction is mounting

Banks are discovering that there will be a regulatory price to pay for the support of governments and central banks – and it could be a costly one. Karina Robinson investigates.
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The political dimension of the banking crisis is broadening as it feeds into the real economy. The US recession – what legendary investor Warren Buffett calls a “common sense” recession as opposed to a technical definition – and the UK slow-down are already evident, while EU growth forecasts have been scaled back. As people see the value of their homes fall, find banks less willing to lend money and feel the effect of rising inflation allied to average wage growth that has already not kept pace during the boom years, the calls by bankers and regulators to avoid knee-jerk reactions are sounding ever fainter in the ears of the politicians, while those of their voters and the popular press seem ever louder.

Add in to this mix the headline effect of bank bail-outs and huge pay-outs for failure to the likes of Merrill Lynch’s former CEO and chairman Stan O’Neal and the words of the apprehensive chief executive of a London-headquartered bank ring true: “You have the makings of a Pavlovian reaction – the “something must be done [effect],” he says, noting that regulators, many of whom believe the crisis needs to be studied further before any actions are taken, will not be able to resist the pressure: “Politicians may push them into it.”

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Additionally, unpopular UK and US governments are not well placed to resist populist calls for quick action to punish the banks and, as EU internal markets and services commissioner and former Irish finance minister Charlie McCreevy points out: “From my experience in government, 99 out of 100 times, a knee-jerk reaction is the worst.”

The US’s Sarbanes-Oxley Act is a much-quoted case in point. Passed quickly and universally applauded at the time, the reaction to the corporate scandals of Enron and others dealt a harsh blow to New York’s status as a financial centre and to the US more generally.

EU response

To the surprise of many, the EU has been wary of overreaction. This is due partly to a European Commission with a free market bias, partly to problems of co-ordinating the positions of 27 members and partly to its powerlessness in banking regulation, which is still carried out at a state level even among members of the eurozone. The Markets in Financial Instruments Directive (MiFID), after all, had to be incorporated into national law before taking effect.

The commission will put forward amendments on changes to the Capital Requirements Directive (CRD) in September 2008. These will then have to be agreed with the European Parliament for further action. Mr McCreevy argues that this measured, longer term process will result in a “more balanced, more considered and therefore more appropriate” response to the need for change.

More co-ordination among EU banking supervisors is a given (see Viewpoint, by former ECB board member Tommaso Padoa-Schioppa) because a nightmare scenario exists: “What if Northern Rock had been a big player in six European countries?” asks Mr McCreevy. Although necessary, the way that increased co-ordination works may have implications for the amount of regulatory burden that banks will have to bear.

What is indisputable is that changes in regulation are needed, not least because of the cost of the crisis to governments and taxpayers. The disagreement between regulators and bankers – who are more often than not on the same side in this – and politicians is about how fast and how deep those reforms need to be.

In the US, with an unpopular outgoing administration, no action is expected until 2009, at which point analysts believe that the country’s banks will be cudgelled with new laws – with the current US bias towards extraterritoriality, this will also probably impact on foreign banks doing business there.

But in the UK, the backlash has begun and it may provide some indications of what will happen in other jurisdictions.

The UK tripartite

The reputation of the UK’s much-lauded tripartite model of financial regulation and supervision, introduced in 1997, studied by academics and imitated by some emerging markets, lies in pieces. Not all developing countries bought into the model, though. While setting up Kazakhstan’s banking regulation framework, former central bank governor Grigori Marchenko looked at different systems and concluded: “When you have three agencies responsible for something, you create a Bermuda Triangle. If something goes wrong, who is responsible?”

That point was brought home with a bang when Bank of England governor Mervyn King, in answering the question posed by the UK’s Treasury Select Committee during hearings on the Northern Rock debacle about who was in charge, ludicrously replied: “What do you mean by ‘in charge’? Would you like to define that?”

A new law allowing for intervention and nationalisation when a bank is in trouble has been quick-marched through parliament: The Banking (Special Provisions) Act 2008. It is a necessary law because the old days of the Bank of England using its influence behind closed doors are evidently over. But, as the chief executive of a local bank points out, the devil is in the detail.

Philip Dunne, a member of parliament from the opposition Conservative Party, who sits on the Treasury Select Committee, points out that the new law allows for the UK Treasury to be in charge of any bank that has to be nationalised when it has no historical expertise in the field. Additionally, about half of the staff at the Treasury have only been there for three years, and 80% of them have only ever worked for the Labour government.

Consultation worry

Detail is exactly what Angela Knight, chief executive of the British Bankers’ Association (BBA), which represents banks operating in the UK, is worried about in the consultation proposal titled Financial Stability and Depositor Protection: Strengthening the Framework, which was launched at the end of January by the tripartite.

“The broad objectives are something that we can give agreement to, but when you look at the detail, there are potentially some issues that involve costly regulatory change,” says Ms Knight. She points out that the document contains 29 legislative proposals, 23 significant policy initiatives labelled operational changes, plus rule changes on which the Financial Services Authority (FSA) plans to consult. The consultation period finishes on April 23 and legislation is due to be introduced in parliament by the summer – a breakneck speed for the most far-reaching changes to the banking regime in a decade.“Legislation is being drawn up as we speak,” Ms Knight told The Banker in March, implying that the authorities were perhaps not as open to suggestions from bankers as the word ‘consultation’ suggests.

The BBA is most worried about three issues. First is the new insolvency arrangements for banks, which will have far-reaching implications for property rights and might complicate the impact of failing banks. It says it has “lawyers in knots”. Second is the proposed ‘single customer view’, which would force banks to spend vast amounts on upgrading their infrastructure. And third, it notes: “Pre-funding the depositor compensation arrangements is neither workable nor relevant in the UK market.”

Richard Lambert, director-general of the Confederation of British Industry (CBI), the UK’s business organisation, noted that such a regime, with a £13bn pot, would be expensive, pro-cyclical and would take money out of the system, while being unnecessary to ensure a speedy pay-out.

Costs of consumerism

In the past decade, many bankers had been warning the then UK chancellor Gordon Brown that the authorities’ consumerist agenda was costing the banks dearly in terms of management time and money. They cited charges for small businesses, overdraft charges for personal bank accounts and payment protection insurance, among many other campaigns.

The chief executive of a major UK-headquartered bank says: “Perhaps as a result of the pandering to consumers by the FSA, there was less focus and resource on the prudential part.” He makes the point that in reality, banks have five regulators: the Financial Ombudsman, the Office of Fair Trading, the Banking Code Standards Board, the Competition Commission and the FSA.

The resource side is always going to be a problem with an organisation that needs to recruit specialists who are capable of understanding, if not anticipating, the banking industry and its innovation. It is not surprising that five of the seven main supervisors of Northern Rock in the past two years had left the FSA – financial services firms pay higher salaries and, unlike the US’s Securities and Exchange Commission (SEC), there is not enough prestige attached to the UK regulator. That is undeniably why the FSA had no luck in a two-year search to find a new chief executive from the City. It appointed Hector Sants, head of its wholesale and institutional markets division, to the job in July 2007.

The sound of stable doors banging shut after the horse has bolted is rife, with the FSA announcing a new supervisory unit to help oversee banks’ risk models. Meanwhile, enforcement has been neglected.

Andrew Hart, who leads the litigation side of banking regulation at law firm Freshfields Bruckhaus Deringer, says: “The enforcement division of the FSA has been under strength in the UK. The FSA does not regard itself as an enforcement-led regulator. The way it works is rather more subtle than the SEC.”

Bank of Spain and IFRS

The search for a better model of regulation has led to calls to imitate the successful Spanish model, with what critics call its more onerous requirements and enthusiasts call old-fashioned banking. There are undeniable attractions but a few caveats are in order, not least the fact that the Bank of Spain is in charge of a much smaller financial services industry than the UK’s and one that is much less exposed to the investment banking business.

That said, José María Roldán, director general of banking regulation at the Bank of Spain, believes there are lessons for international banking regulation. “Our banking model has protected us. Spanish banks hold over 1% of their balance sheet in generic, counter-cyclical provisions and have non-performing loan (NPL) coverage on average of around 230%,” he says, noting that NPL coverage of about 50% is more usual in the banking industry. The banks are allowed to draw down the 1% of generic provisions in the bad times.

Those sums look absurd in the good times; now they look like admirable prescience. But then, as Jaime Caruana, former governor of the Bank of Spain and now head of the the International Monetary Fund’s monetary and capital markets department, says: “The test for good regulation is not just the bad times, when risks materialise and you are busy managing the crisis; it is the incentives you create in good times, when risks are taken.”

However, the arrival of the International Financial Reporting Standards (IFRS) accounting rules are a blow, if not a mortal blow, to the Spanish rules because such large, non-specific provisions are not allowed. The Bank of Spain is looking to see how to adapt to IFRS without sacrificing its philosophy.

The IFRS’s mark-to-market rule is proving a major problem for banks, which argue that it forces them to exaggerate greatly the losses in illiquid markets and is detrimental to financial stability. Some banking regulators have been arguing this point with the accounting bodies to no avail. That is now changing. Policy makers, including EU finance ministers, the International Accounting Standards Board and bankers, are discussing how to improve valuation standards of complex financial instruments.

Scotiabank president and CEO Rick Waugh, who chairs the Institute of International Finance (IIF) committee of market best practices, said at the organisation’s spring meeting in Rio de Janeiro: “[Mark to market] is like a car. We all know we should have an environmentally friendly car but you need to make sure it works before you put it on the road. Some of the well-intentioned regulations were not stress [tested] but now they are being stress [tested] with unintended consequences.” The IIF is doing its best to stave off the worst effects of a regulatory backlash by coming up with its list of reforms and in a report, due to be published in April, about 70 detailed recommendations are expected.

Basel II

There is much misplaced criticism of Basel II and its role in the crisis, argue regulators who have been working on it for a very long time. “It would be madness to go for Basel III now. In Japan, they implemented Basel II before any of us and you could argue that it has helped them with the crisis. Instead, we must consider what aspects of Basel II can be improved. Pillar 3 on transparency needs more work, and Pillar 2 on regulatory oversight,” says Bank of Spain’s Mr Roldán.

Basel II is not to blame for the current crisis. However, its reliance on the internal risk models of global banks – note that Merrill Lynch’s value at risk was lower than that of its competitors – and on rating agencies is the opposite of what is needed now, say critics. Nor is its emphasis on capital and solvency helpful, nor its lack of emphasis on liquidity.

Charles Goodhart, emeritus professor of banking and finance in the London School of Economics financial markets group, is worried that Basel II’s introduction raises the sensitivity of banks’ capital adequacy ratios to risk and that many banks will see their capital cushions eroding fast, which will extend and amplify the crisis.

He is dismissive of the much-vaunted originate-and-distribute banking model, which he says was “pretend to originate and pretend to distribute”. Banks either have to support off-balance sheet vehicles conduits and special investment vehicles and run down their resources, or not support them and get their names dragged down, he says.

He is not a fan of Basel II. “The tendency to have one single standard, whether Basel II or accounting, is that it tends to make everyone behave in the same way. It enhances herding instincts. Have our financial institutions become lemmings?” he asks.

There are other flaws in Basel II, notably Pillar 2 on stress testing, says Roger Martini-Facio, head of risk and compliance for financial services at IT and business consultancy firm Logica in the UK. He believes it is not in the banks’ interest to stress test extreme or even difficult scenarios because it might mean they would have to hold more capital in reserve, thus depressing returns.

He is also sceptical about the FSA’s ability to analyse the results of the tests. “Does the regulator have people who can look at these stats? No, because there is a need to pay a lot for quants [quantitative analysts],” he says. “And the banks pay for the FSA; they don’t want to pay more.”

Modifications in mind

It is too early to say in detail what modifications will be made to Basel II, but more transparency looks likely plus larger powers for the regulator and a requirement for banks to hold more liquid assets on their balance sheet, depressing their returns and turning them more into utilities. Sir Howard Davies, a former chairman of the FSA, noted in a Viewpoint for The Banker (January 2008) that UK banks in the 1970s typically held about 30% of their assets in highly liquid form. The current figure is nearer 2%.

Whether a new ratio for liquid assets will help is hotly debated in regulatory circles. A required quantitative minimum reserve may worsen the situation, says Professor Goodhart, because banks will not be able to sell the assets. He thinks the solution is to “encourage” banks to hold them – rather than make it a requirement – and then allow them to be run down in troubled situations.

Others contend that the current crisis is not one of liquidity, but one of confidence, and that any moves on the liquidity front are irrelevant to the crisis and damaging to banks.

But bankers will have to explain that to the politicians. Bankers have already been explaining their pay packages to politicians, and not very convincingly. The spectacle of Mr O’Neal at a hearing in the US Congress in March, excusing his $161m retirement package from Merrill Lynch as “deferred compensation, stock and options that I earned during the years prior to 2007”, was not likely to endear him to his listeners.

Most bankers interviewed expressed total scepticism about tying pay-outs to long-term risk. They noted that when, in 1991, investment guru Warren Buffett ‘parachuted’ into Salomon Brothers following a scandal and began cutting bonuses as part of his clean-up effort, other Wall Street banks benefited from the ensuing exodus of bankers.

It is difficult to see by what mechanism governments could get involved in the intricacies and complications of banker remuneration, but that does not mean that it will not happen in an industry that is heavily regulated and is dependent on government goodwill in countless ways.

Rating agencies

The rating agencies – mainly the two most powerful ones, Moody’s and Standard & Poor’s – are the whipping boys for all protagonists in this drama. They are accused of conflicts of interest and shoddy analysis, while the fact that professional investors were so hungry for yield that they did not use much judgment is glossed over.

Even the defenders of the rating agencies are lukewarm. Professor Goodhart says there is no proof that they were corrupt or feathered their own nests, although they may have been too close to some of the financial institutions, while there were conflicts of interest, but “only at the margins”.

A source at Moody’s tells The Banker that in the structured finance areas there is not always an arm’s length relationship between analysts and those involved in negotiating the fee for the rating service.

Additionally, the source says that the managing director of each business line within structured finance is given a growth target that leads to a temptation to give an acceptable rating to fulfil the revenue quota.

Moody’s denies the accusations. “At Moody’s, analysts are not involved in fee negotiation. There is a dedicated issuer relations team, separate from the ratings team, that is responsible for fee discussions,” says Frederic Drevon, senior managing director Moody’s Europe, Middle East and Africa.

The rating agencies already subscribe to codes of conduct, such as that of the International Organization of Securities Commissions, and say they will be participating in the reviews of this code, modifying their internal rules accordingly.

That, however, will not stop a backlash against them – a worst-case scenario is that they will be broken up. A best-case scenario, say analysts, is that they will be forced to become more accountable and transparent.

Backlash begins

“If the industry wants to avoid a regulatory backlash, it must show itself capable of stepping up to the mark. Not with a grudging de minimis approach, but with real leadership and commitment,” said Mr McCreevy in a speech a couple of months ago.

The problem is that getting banks to agree on proactive measures, which will steal the thunder from the politicians, is almost impossible – not least because those banks that are not as exposed see no need to make common cause with those that are “still dancing” (to use the hubris-like words in July last year of Chuck Prince, then chief executive of Citigroup).

“If you start to clamp down on creativity and innovation, you would end up with the civil service populating the banks,” says one bank chief executive.

In the midst of the crisis, that warning may sound extremely attractive to politicians. The banks have, understandably, lost the public relations battle. A regulatory backlash has started, at least in the UK. It is too early to say what the consequences will be on a global scale. Except, perhaps, that it will cost banks a lot and that it will have unintended consequences. The challenge facing the banks and their allies is how to contain it.

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