Regulators and governments must not make the mistake of responding in haste to recent crises, such as German bank failures, the Northern Rock debacle and liquidity problems, advises Howard Davies.

The financial crisis of 2007, which rolls on uncomfortably into this year, has brought more than its fair share of calls for wholesale reform of financial regulation.

The German government – clearly embarrassed by the failures of some of the banks it owns – has led the way with attacks on “snooty” bankers (maybe it sounds more serious in German) and demands for new constraints on securitisation, on ratings agencies, private equity firms and sovereign wealth funds and, of course, demands for a cull of the locusts in wicked hedge funds.

Perhaps some of this rhetoric should be treated simply as political throat-clearing. There is no real harm in that, you might think. But the risk is that in the heat of battle, governments and regulators are tempted to impose new controls off the cuff. And one lesson we ought to have learnt by now is that regulations conceived in haste are often repented at leisure. The Sarbanes-Oxley Act is a recent vivid example.

Supervision ruckus

In the UK, the Northern Rock episode, perhaps not the UK’s finest hour, has led to calls from opposition MPs to tear up the tripartite agreement between the Treasury, the Bank of England (BoE) and the Financial Services Authority (FSA), and to return banking supervision to the bosom of the BoE, from which – some say – it should never have been untimely ripped.

As there seems to be no proof that the problem was one of co-ordination between the BoE and FSA, while there is ample evidence that understanding Northern Rock’s problems required an understanding of what was happening in securities markets; to delink banking and securities regulation would be a curious response. It is not clear that the BoE is yearning to take this tiresome infant back to its bosom. I hope the Treasury Committee does not take that path.

But is it the case that nothing need be done? Should we accept that crises like this are bound to happen and simply shrug our shoulders, waiting for the storm to pass?

I do not think so. There are certainly problems in the US mortgage market that need closer attention. Subprime loans doubled their share of the market without anyone in authority asking whether lending standards were being dangerously relaxed. There is a European regime of broker regulation that the Americans might usefully copy.

There are issues, too, in the securitisation markets. For now, market participants have lost so much money that we do not need to worry about an early revival of the practices at the height of the boom. But Jean-Claude Trichet of the European Central Bank is right to call for more transparency. Uncertainty about where the losses lay was a powerful factor behind the midsummer liquidity crisis.

Then there are the ratings agencies. It is easy to say that their business model is plagued with conflicts of interest – but somewhat harder to devise a new one that is not. Part of the answer is that banks and investors should not think that ratings are a substitute for thought, and should rely on them less. But the agencies themselves need to work harder to demonstrate that their ratings staff are not influenced by commercial considerations, and to put in place mechanisms that protect them. The securities regulators will have to oversee those arrangements more closely.

Liquidity lessons

And then there is the fraught question of liquidity. Have regulators paid too much attention to bank solvency and too little to liquidity and the risks posed to particular business models if liquidity dries up? That seems to be one lesson from Northern Rock. Charles Goodhart of the London School of Economics has argued that this is the next great challenge for the Basel Committee, and that banks may have been unwisely allowed to hold far fewer liquid assets than they used to. In the 1970s, UK banks typically held about 30% of their assets in highly liquid form. The current figure is nearer 2%.

Increasing that proportion materially would be expensive. We should not require it without careful thought and strong justification. But the arguments are stronger than they seemed a few months ago. That, I forecast, will turn out to be the next great debate between the regulators and the regulated.

Howard Davies is a former chairman of the UK’s Financial Services Authority.

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