Parallel Lies

British Prime Minister Gordon Brown has been talking with President Obama this morning, and high on the agenda was the PM’s call for international banking regulation. The interesting thing is that both Obama and Brown have blamed lack of regulation for the banking crisis, when there is clear evidence on both sides of the Atlantic that it was bad and inept regulation that drove the crisis. For an example from the US, here’s John Carney on how bad regulations helped destroy AIG. Over in the UK, the Taxpayers’ Alliance has an excellent study that outlines numerous ways in which regulations and regulators contributed to the UK’s own crisis. Here are its conclusions:

A poor response from regulators

* Unclear and restrictive EU Directives limited the Bank of England’s response to the crisis at Northern Rock. In particular, the Takeover Code and the Market Abuses Directive were felt to preclude an inter-bank rescue operation and covert lender of last resort assistance respectively. Mervyn King, Governor of the Bank of England, argued that these prevented effective support being given to Northern Rock.
* Deposit protection was not sufficient to give bank customers confidence. In particular, the time it takes for the Financial Services Compensation Scheme to pay out and failures to make other government payments promptly may have led depositors to believe their money would effectively be frozen for months in the event of a collapse.
* The tripartite system meant that the Bank of England lacked the information needed to properly assess whether lender of last resort actions were appropriate or not. Despite the ineffectiveness of regulatory oversight, compliance costs rose substantially for banks after the Financial Services Authority took over supervision.
There had been concerns for some time before the crisis about problems at the Financial Services Authority. Prominent voices criticised a lack of quality staff and insufficient focus on systemic risk, but sufficient changes were not made.

How regulations exacerbated the crisis

* Capital adequacy rules in Basel II are based upon borrower default risk – the chance that companies and mortgages will go bust. This means that capital requirements will tend to increase as an economy falls into recession and fall as an economy is expanding. Studies for the US Federal Reserve System confirmed that the rules are procyclical as far back as 2004. It is clear that the rules worsen financial crises.
* Common capital adequacy rules encourage firms to hold similar assets and respond in similar ways in a crisis. This amplifies herd behaviour. At the same time, common international rules mean that booms and busts in individual countries are likely to take place at the same time, increasing the amplitude of global credit cycles.
* Mark to market regulations rely upon the market to provide a price for an asset and cannot function when that market temporarily ceases to exist, as the market for many assets did at the beginning of the financial crisis. Had mark to market regulations been in place in the 1980s every one of the United States’ ten largest banks would have become insolvent.
* Regulations, particularly restrictions on short-selling, did serious damage to hedge funds. This not only damaged the funds themselves but exposed troubled banks to further risks and closed off some means of funding, in particular by preventing banks being able to raise capital through issuing convertible bonds.

In one sense both the PM and President are right. The global system of financial regulation is broken, but what the two leaders are thinking of doing is merely putting red tape over the cracks.