In a recent speech to the Global Financial Forum, Lord Turner, chairman of the Financial Services Authority, expanded on three themes from his recent review of banking regulation. He stated that “a major objective must be to return banking to its basic functions – providing vital services of real value to the real economy.[1]” Turner hinted at regulations that are likely to be introduced over the course of the next few years; however at this early stage many questions remain about what form this new regulation will take, and perhaps more importantly, how can it be effectively implemented and enforced in the wake of the recession?
The severe dimensions of the current financial crisis was unexpected for everyone; although, economic fluctuations and boom-bust cycles have been analysed for many years. Previous crises have allowed governments to develop crisis management skills in order to cope with contractions in the economy, and past experience has shown that after a crisis, things tend to go back to ‘business as usual’ leaving the culture of risk taking relatively unaffected.
Global impact
Conversely, the unique aspect of this recession has been its near-global impact leading to further complications when planning how to ensure that a similar event does not occur in the future. This is probably the end of the "magic of the marketplace" belief that has been prevailing since the 1980s, believing that the shareholders should be able to regulate the banks’ behaviour in order to ensure the long-term survival of their investment. It is clear that banks in the UK have failed to regulate themselves through their shareholders and executive boards, and this has been at a huge estimated cost to the British taxpayer. It is therefore untenable that the government could let lenders revert back to their old ways, and must step in to guarantee the future of the British financial system.
New regulation as proposed will have a dramatic impact on banks and commercial lenders. In his review of banking regulation, Turner suggested that banks large enough to threaten the stability of the financial system should be subject to higher capital requirements. He also warned large banks with operations overseas that regulators may require their local operations to be "separately and strongly capitalised" and hold their own reserves of cash for daily operations. However it is important to note that this is being discussed in the context of the current recession where we need banks to continue lending to restore the economy.
Priorities
Any new regulations must be implemented carefully and on a specific timeframe in order not to make the situation worse. Lord Turner warns that the transition to higher bank capital will need to be managed carefully. “UK banks are now capitalised at a level which will enable them to absorb severe stresses, and the short-term priority is to maintain bank lending to the real economy”[2]. As noted by Angela Knight of the British Bankers’ Association, “Regulatory reform needs to strike the right balance between restoring financial stability and fostering a return to healthy and sustainable growth.”[3]
The most immediate impact on the commercial lending and banking industries is likely to be the stricter enforcement and supervision of existing regulations. New regulations cannot be successful unless they are built on a solid foundation of clear, enforced rules. In the past, the FSA has admitted that it has been too soft on its supervision and controls. However, this approach is quickly changing through the Supervisory Enhancement Programme (SEP), as reflected by the heavy fines recently levied on Morgan Stanley and the banning of a rogue trader that worked for the investment bank[4].
Successful supervision
In order to successfully supervise banks and lenders, the FSA must ensure that the banks have proper control of their operation. This will be especially important where cross-border regulation comes into play. At this early stage, it is too soon to predict how exactly this will impact upon the banks, which may need to improve their processes for data capturing, risk assessments, measurement and reporting. Whilst this may prove unpopular initially, if new measures are not implemented with a high level of quality then this could lead to further problems and diminish the FSA’s ability to supervise effectively.
The implementation of the new regulation and stronger enforcement of existing regulation must be considered in the context of an uncertain future. The Bank of England’s recent inflation report “shows that in two years’ time it is quite possible that the economy will have grown at more than 3 per cent over the previous 12 months. But it is equally possible that it will have shrunk”.[5] For this reason, in his recent speech Turner stated that “we need to design a banking system and credit intermediation system focused on its core and essential functions in the real economy and better able to be a shock absorber rather than itself a source of instability”.[6]
Simple and transparent
To achieve sustainable success in the new financial world banks need to return to a more simple and transparent banking model, dubbed by Alistair Darling as a move back to “old fashioned banking”[7]. In this scenario, banks must base their lending on the real economy i.e. economy based on good quality earnings, rather than the predicted economy of the future, as many financial crises start with a misconception of what the future economy and earning growth will look like. This will involve a major cultural shift, which will not be an easy transition as the culture of high risk taking dates back to the deregulation that began in the 1980s.
Whilst it is unquestionable that regulation will form a crucial part of the new world of banking, we must come back to our original question relating to its implementation. A careful and timely implementation of any new developments will be required to ensure that the current situation is not worsened. Moreover, building on a stable foundation of effectively managed and enforced ground rules will allow any new regulation to have a greater chance of success. For as Winston Churchill stated “If you have ten thousand regulations you destroy all respect for the law”.
1 http://www.fsa.gov.uk/pages/Library/Communication/PR/2009/056.shtml
2 http://www.fsa.gov.uk/pages/Library/Communication/PR/2009/037.shtml
3 http://www.bba.org.uk/bba/jsp/polopoly.jsp?d=145&a=15786
4 http://www.guardian.co.uk/business/2009/may/13/rogue-trader-fined
5 http://business.timesonline.co.uk/tol/business/columnists/article6283309.ece
6 http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2009/0427_at.shtml
7 http://uk.reuters.com/article/businessNews/idUKNOA32312620070913
