The spirit is willing, but the banks are weak | FT Alphaville

The spirit is willing, but the banks are weak

“We need to … recognise, that in finance and economics, ill-designed policy is a more powerful force for harm than individual greed or error.”

Lord Adair Turner, FSA chairman

Although perhaps there’s no policy more ill-designed than one that relies upon the judgement (and thus, possible error) of those who conduct policy.

Something to ponder as the financial system moves closer to so-called prudential regulation.

Andrew Bailey, the Bank of England’s chief cashier — i.e. the man whose signature graces the banknotes in your pocket — made a very thoughtful speech on the topic on Tuesday. As he observed (emphasis ours):

First, a competitive financial system can only exist if it is rooted in stability: competition and stability cannot be traded off in a binary sense. Second, the public should not define financial stability as preventing all financial firms from failing. In other sectors of the economy firms fail without putting at risk the funds of the public or taxpayers’ money. …

And third, regulators must use their judgement to mount a robust challenge to stop dangerous business models and investment practices. This last point is vital. Financial services is an industry where arbitraging rules and regulations is habitual, even addictive. Money is made this way. We have no desire unduly to suppress enterprise and innovation, but doing the right thing and preserving financial stability means accepting the spirit of the rules. This is not a small change. Let me give you one important example. The new Basel agreement emphasises loss-bearing capital – capital that can bear losses outside insolvency. It must stay that way, and not be chipped away under the banner of arbitrage masquerading as innovation. I have been asked a number of times in the last week whether I think that the new Basel agreement sets capital requirements high enough. My answer is that if the capital buffers are in future genuinely loss bearing capital with no tricky wrinkles, and we keep to this outcome, we have taken a good step forward. Sadly, that was not the case with Basel 1 in the late 1980s when I started out as a banking supervisor.

So why will it be the case with Basel III?

Basically because Bailey reckons the UK’s future Prudential Regulatory Authority will able to think ‘around’ the rules in the same way as banks:

The PRA will exercise judgement in the supervisory actions it takes, so that firms are likely to be able to meet its objectives, policies and rules over the medium term horizon. Firms will need to demonstrate to the PRA that they are robust to a variety of states of the world, including unanticipated stress scenarios. However, since it is not possible for any forecast to cover all possible outcomes, there will always be some probability of firms failing. Working with the Bank of England’s Resolution team, the PRA will need closely to integrate recovery and resolution planning within its supervision; and in my view should embed a proactive intervention framework…

Thus making sure Basel’s emphases on loss-bearing ‘stay that way’. It’s better than just asking nicely if banks can play by the spirit of the rules.

Of course, Bailey would cheer on the PRA — he’s due to become deputy chief executive there. But then macro-prudence is very much in vogue nowadays in any case.

Which is great — but there’s a danger here that we’ll end up with a Green Lantern theory of finance. (With a tip of the old hat to Matthew Yglesias’ original use of the term with regard to foreign policy).

Basically, the comic-book superhero Green Lantern wears a cosmic ring that grants him powers limited only by his own will.

Not dissimilar, then, to the idea that all financial regulators need is to be a little more willing to pronounce judgement and to bear the trade-offs this involves, once they have the actual rules (or, er, super-powers) required.

If only it was as simple as that. For a start, if it’s about judgement, you’re bringing it down to the individuals who make those judgements. When it comes down to that, bankers seeking arbitrage will always outnumber the regulators trying to stop them — and will always have stronger financial incentives at the personal level to do so.

Moreover — individuals only have individual lifetimes of data to go on. In particular, we’ve already noted with regard to Basel III’s scheduled eight years’ implementation time that a lot can change within financial markets during a decade — new asset classes, new forms of liquidity… and new arbitrage.

Never mind the Green Lantern — this looks like a job for Superman.

Related links:
Basel as MMORPG – FT Alphaville
‘Capital requirements increase systemic risk.’ Discuss. – FT Alphaville
From Bank of England to Bank of Everything – FT Alphaville