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A dangerous embrace A bank regulators lot is not a happy one

May 12th 2011 | from the print edition A SOLDIER HUNCHES over the sights of a heavy machine gun. Its barrel points at the main gate. Out in front, guards briskly move on any cars that loiter. The headquarters of most central banks are described as fortress-like. Few seem quite as impenetrable as that of the Reserve Bank of India. Its department of banking supervision guards the countrys financial system with equal zeal. Whenever there is a crisis the state will have to intervene, says K.C. Chakrabarty, a deputy governor. If the state ultimately has to intervene at the very last stage, then why not intervene at the very first stage?

In India bank supervisors sit on the committees that choose managers of banks owned by the state or get a say on whether the nominated directors of private banks are fit and proper. They even help to decide how old non-executive directors should be and how much they should be paid. The central bank also determines what products banks are allowed to sell and has banned all but the simplest of derivatives. It tells banks where they should lend and where they can open branches (which applies to foreign banks as well). The banking we are protecting in my country is Scottish banking from 150 years ago, says Mr Chakrabarty.

Hands-on regulation of this sort is far more common around the world than the freewheeling variety that banks in the worlds financial capitals have got used to. In poorer countries banking is seen as a tool of development wielded through ownership and regulation. In China it is often difficult to tell where the Communist Party ends and the banking system begins. In Russia a state-owned bank, Sberbank, dominates the market. In most of the Gulf region banks count the state among their largest shareholders. In African and Asian countries that have private as well as state-owned banks, supervisors keep them on a tight leash. Theres a positive attitude towards (banking) regulation in parts of Asia compared with a negative attitude in America, quips Tab Bowers of McKinsey in Tokyo. In

Asia they tell you in a positive sense what you are allowed to do instead of telling you what you cant do. Before the financial crisis such restrictions were seen as signs of backwardness. In general, banking and capital markets the world over had been steadily liberalising. Limits on foreign ownership of banks and on the kinds of transactions they were able to engage in were being lifted. Rich countries with fairly open markets were deregulating faster than others. In 1999 America repealed the Glass-Steagall act, a Depression-era law separating investment and commercial banking. Across the rest of the rich world banks were given greater leeway on how much capital they should hold and how much risk they could take on. Levels of capital dropped and balance-sheets ballooned.

The crisis put an end to that. Supervisors in many developing countries are now saying that tight regulations saved them from getting into trouble. (Their banks may also have had better things to do with their money than buy worthless claims on American mortgages.) At any rate, regulators now have a good excuse to slow or even reverse the opening of financial markets. In so doing, however, they are also keeping out some rather useful financial innovations that got themselves a bad name. India, for instance, could make good use of securitisation to help it channel the vast sums of money it needs to spend on building ports, roads and railroads. But now regulators are inclined to ban first and ask questions later. Stop, or Ill regulate In the old days, in so far as they worried about the risk of banks going bust, regulators usually relied on simple measures of health, concentrating on making sure the right paperwork was in the files, says one senior regulator. It was a wood-and-trees problem, says another official. You would go in and come up with a list of 45 things a bank could do better, but you would not be saying: What are the five important things that could threaten this bank? In the new world of regulation, supervisors are still doing some of the things they have always done. They are tightening capital standards (see article) and looking far deeper into the inner workings of banks, down to the plumbing that connects them to one another. Regulators have

gone from saying tell me all your [payment] systems work to saying show me how they work, says Simon Bailey, of Logica, a technology firm. They are shining a pretty bright light on parts of the banking system that are massively complex and, if Im being polite, slightly dusty. Far more controversially, though, regulators are now also tentatively stepping over a longstanding divide between enforcing basic rules and playing a part in business decisions. In regulator-speak the difference is between conduct regulation and prudential regulation. Under the old rules supervisors were simply referees trying to ensure that the game was played fairly. The shift is particularly marked in Britain, which once championed light touch regulation. Its pre-crisis reticence is now pilloried as a craven surrender to the banks or as a selfserving device for attracting financial activity to Britain. In truth it was neither. The main motivation was the well-intentioned belief that markets are better than governments at allocating resources. In America, too, regulators were reluctant to squash innovation because they thought, in the words of Alan Greenspan, a former governor of the Federal Reserve, that the self-interest of lending institutions would be enough to ensure they did not all leap from the same tall building. Regulators are now tentatively stepping over a long-standing divide between enforcing basic rules and playing a part in business decisions In rich countries enthusiasm for new forms of prescriptive supervision seems to be directly proportional to the degree of harm suffered during the banking crisis, or to the threat from failing banks to bring down their governments with them. Britain, which used a larger share of GDP than most other big countries (though far less than Ireland) to prop up its banks, is going further than most to rethink regulation. It has not only reshuffled its entire supervisory apparatus, moving oversight of banks back to the Bank of England; it is also talking about introducing some of the biggest capital buffers in the rich world and telling banks how big they can become. Switzerland, home to two huge banks, UBS and Credit Suisse, each of which at the time of the crisis had assets at least twice the size of the countrys annual GDP, is also proposing unusually strict capital rules and giving regulators a say over its banks business decisions. America, whose banks suffered huge losses in the crisis without threatening the solvency of the government, is taking a more moderate approach. There, too, however, supervisors are scrutinising business plans and are allowing only selected banks to pay dividends or buy back their shares. Depression-era legislation preventing speculation by commercial banks has been dusted off and passed as the Volcker rule, restricting the ability of banks to trade on their own behalf. At first glance it seems sensible that regulators should pay attention to banks health as well as to their conduct. Regulation, after all, is the price that society demands, and banks pay, in return for the implicit promise of a government bail-out if the worst happens. The reason banks are regulated and hairdressers are not is that a badly run barber poses little danger to outsiders. Banks, on the other hand, cause widespread chaos when they collapse. One sick bank going broke can destroy confidence in the entire banking system and start runs that could bring down healthy banks too. Most advanced economies try to prevent that by offering deposit insurance to savers. They also regulate banks to make sure they do not gamble with savers protected deposits. But it is not easy to stop banks from making bad decisions. In the past regulators have tended to leave it to the market to judge the health of banks, not least because they themselves did not feel up to it. Legions of clever, well-paid investment analysts and investors failed to see the crisis coming. Those who did are remembered mainly because there were so few of them. Now central

bankers and supervisors are expected to make a better job of it, but most would prefer not to get too involved. We dont want to get into the business of making very close business judgments, says one American official, but we are making a judgment of our own about whether they have a coherent strategy and coherent risk management. One problem is that rules and laws are written with the benefit of hindsight. The good ideas that might well have prevented the last crisis, however, can make regulators dangerously overconfident about being able to predict and prevent the next one. Take Royal Bank of Scotland, the bank that in 2008 needed Europes biggest bail-out. Supervisors on both sides of the Atlantic concluded that the banks heavy reliance on wholesale markets (very short-term loans from companies and other banks) left it especially vulnerable to running out of money when confidence collapsed. They should never have been allowed to do that, says one central banker Its not rocket science. But at the time it was much less obvious. And a number of other things went wrong with the bank, including its ill-conceived takeover of ABN Amro, the worlds largest banking merger at the time, and its expansion into American mortgage markets. Regulators might have prevented the bank from relying so much on wholesale markets, but a disastrous takeover could have wrecked it as well. Bank supervisors can impart only so much common sense to those who think they know best. Just when you thought it was safe Besides, the regulators reluctance to second-guess bank executives was well founded, because it can take them onto dangerous ground. If regulators underwrite certain strategies that seem safe, such as lending to small businesses or helping people buy houses, they may encourage banks to crowd into those lines of business. That can drive down interest rates and lending standards and push up asset prices. If enough banks pile into these markets, downturns in them can affect not just a few banks but the whole system. Paradoxically, the very act of signalling that a market is safe can make it dangerous. It also introduces a form of moral hazard, because banks and their creditors may assume that the government would be duty-bound to bail them out if a closely monitored institution were to fail. On the other hand over-strict regulation can also be harmful if it stifles financial innovation and squeezes all appetite for risk out of the banking system. In Japan (see box) a banking crisis that started more than two decades ago still lingers on, in part because the countrys bankers have become gun-shy and tend to buy government bonds rather than lend money. And even if supervisors rule wisely, they have to keep it up year in and year out to remain effective. I worry that supervision is an endless process of having to get better, says a senior regulator in Britain. You have to keep hiring lots of clever people and you have to avoid atrophy over time. Most regulators are doing all they can to mitigate these risks. Many are concentrating on changing incentives in the banking system, in the hope that this will change behaviour. Yet they also know that in the new world of intensive regulation the very need for it is an admission of failurebecause it implicitly acknowledges that if only banks held more capital, supervisors would not have to work so hard.