Regulating the Regulators
This article appeared in the March issue of The Abacus.
Does deregulation protect the public or give licence to fraudsters?
One often sees features in the Sri Lankan media in which respected entrepreneurs call for further de-regulation in the financial sector in order to ease the business of doing business. It is quite legitimate to criticise the inertia caused by unnecessary bureaucracy and red tape. However, we should remember that it was not an excess of regulation that brought about the financial crisis in the US and the EU. De-regulation is unlikely to protect the public or investors.
Regulators, whether appointed by national governments or international groups, have the task of protecting investors, maintaining orderly markets and promoting financial stability. For example, in 1974, the central bank governors of the Group of Ten countries established the Basel Committee on Banking Supervision (BCBS) to provide a forum for regular cooperation on banking supervisory. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. The Committee also frames guidelines and standards.
In general, regulators promulgate and implement laws and rules that govern what financial institutions such as banks, brokers and investment companies can do. The range of regulatory activities can include setting minimum standards for capital and conduct, making regular inspections, and investigating and prosecuting misconduct.
In a previous article, I indicated that this did not work too well in Ireland. Rialtóir Airgeadais was the sole regulator of all financial institutions in Ireland from May 2003 until October 2010 and was a constituent part of the Central Bank of Ireland. One former CEO was Patrick Neary, who retired early over the handling of the Regulator’s investigation into the €87 million in secret directors’ loans at Anglo Irish Bank.
The German Regulator warned the Irish Regulator in 2004 that a German bank’s Irish subsidiaries were involved in risky and under-scrutinised transactions worth as much as €30bn or 20 times the parent bank’s capitalisation. Despite the warning, in 2007, the Irish Regulator approved another investment vehicle from the same bank. Two months later, the stable of off-balance sheet companies needed a €17.3bn bailout from the German association of savings banks. The German regulator also blamed the Irish Regulator for the failure of another German bank that the German government had to bail out at a cost of €102 billion.
The Financial Services Consultative Consumer Panel said that most Irish consumers lost significant amounts of money because of the inadequacies of the financial regulatory structure. It also criticised the inadequate response of the regulator to threats to consumers, including the Irish property bubble.
Ernst & Young refused to appear before a parliamentary committee following the collapse of Anglo Irish Bank and was investigated about its audits of that bank. Nevertheless, the Irish Regulator hired Ernst & Young to advise on the €440 billion bank guarantee scheme in January 2009.
Transparency International noted that the Irish Regulator had found substantial departures from credit policy during inspections of banks, but failed adequately to follow up on its concerns. One wag likened the actions of the Irish Regulator to “the Vatican running an abortion clinic”. The European Commission in a November 2010 review of the financial crisis said, “Some national supervisory authorities failed dramatically. We know that in Ireland there was almost no supervision of the large banks.”
The possibility of criminal prosecutions against managers in Irish banks who committed offences was compromised because the Regulator was aware of the alleged offences but took no action to stop them. This allowed wrongdoers the opportunity to claim they were acting with the approval of regulatory authorities. Nevertheless, three executives of Anglo Irish are each facing 16 charges of unlawfully providing financial assistance to individuals for the purpose of buying shares in Anglo Irish Bank in 2008. About 350 people volunteered to serve on the jury, giving an indication of the interest in the trial, which may last for six months.
Criminal prosecutions are rare in the US. The Financial Crisis Inquiry Commission, in its final report, uses variants of the word “fraud” no fewer than 157 times in describing what led to the US crisis, concluding that there was a “systemic breakdown,” not just in accountability, but also in ethical behavior.
In Ireland, the failure of regulation arose from a combination of factors: incompetence, lack of intellectual firepower, understaffing, cronyism and plain lethargy. In other countries, regulators are ineffectual for similar reasons; sometimes complexity defeats them. Alan Greenspan wrote that financial regulators are required to oversee a system far more complex than what existed when the regulations still governing financial markets were originally written.
Critics argue that the Commodity Futures Trading Commission, which is tasked with overseeing derivatives that were at the centre of the US crisis, is drastically underfunded. The CFTC gets $215 million to regulate markets. The notional value of the markets the agency tries to regulate is mushrooming from $45 trillion in commodities swaps to a nearly $400 trillion derivatives trading industry.
The argument of the banksters/fraudsters goes: Markets have become too complex for effective human intervention. The only strategy that can work is maintaining maximum freedom of action for key market participants such as hedge funds, private equity funds, and investment banks.
Regulators and legislators, in cosy complicity with the banks, have taken very few real and restrictive measures concerning financial companies.
In the UK, the Vickers Commission presented its recommendations to the authorities in 2011. Vickers said that banks should ringfence their high street banking businesses from their “casino” investment banking arms. Other commissions in France and the EU also recommended ring fencing.
Nevertheless, in January 2013, the Basel Committee postponed the application of one of its principal measures, the liquidity coverage ratio (LCR) regulation, requiring banks to constitute reserves capable of meeting a crisis for thirty days. The measure was to have applied from 2015, but it has been postponed until 2019.The banks may still include toxic products in the LCR. The EC retreated from its plan to protect deposit-banking activities from the undesirable effects that may arise from highly speculative and risky trading activities.
There seems to be no sign that regulators are likely to grasp the nettle of dealing with the banks in such a way that they will be compelled to protect the deposits of ordinary people and finance socially useful production. Banking (the service that should protect savings and supply loans for social uses such as productive development) is too important to be left in the hands of a small number of private bankers who, by definition seek only to maximise their profits.