Why financial regulation is both difficult and essential

By Martin Wolf

Nice try; no cigar. That was my reaction to the attempt of the banking community to forestall additional regulation, by recommending “a suite of best practices to be embraced voluntarily”. It was also the reaction of the policymakers meeting in Washington over the weekend. More regulation is on its way. After frightening politicians and policymakers so badly, even the most optimistic banker must realise this. The question is whether the additional regulation will do any good.

In an interim report on “market best practices”, the Institute for International Finance, an association of bankers, offers devastating self-criticism.* Here then are some of the weaknesses it identifies: “deteriorating lending standards by certain originators of credit”; a “decline of underwriting standards”; an “excessive reliance on poorly understood, poorly performing and less than adequate ratings of structured products”; and “difficulties in identifying where exposures reside”. Would you buy a voluntary code from people who describe their own mistakes in this brutal manner? I thought not. There are two powerful additional reasons for not doing so.

First, in such a fiercely competitive business, a voluntary code is almost certainly not worth the paper it is written on. When they can get away with behaving irresponsibly, some will do so. This puts strong pressure on others. That is what Chuck Prince, former chief executive officer of Citigroup, meant when he told the FT that “as long as the music is playing, you’ve got to get up and dance”. So, as Willem Buiter of the London School of Economics remarks: “Self-regulation stands in relation to regulation the way self-importance stands in relation to importance.”

Second, the industry has form. The IIF itself was founded in 1983 in response to the developing country debt crisis. At that time, big parts of the west’s banking system were in effect bankrupt. Now, many upsets later, we have reached the “subprime crisis”. The IIF was created not only to represent the industry, but to improve its performance. It is clear that this has not worked.

Do not just take my word for it. Last month, Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard published an extraordinary paper on the long history of financial crises.** The chart shows that the incidence of banking crises (measured by the proportion of countries affected) has been as high since 1980 as in any period since 1800; that the incidence of crises is correlated with liberalisation of capital flows; and that there was, until 2007, a decline in the incidence of crises in the 2000s.

Yet why, I ask, should this industry have apparently failed to improve its standards of performance over the past century? After all, almost every other industry has done so. Consider how confident we are that the food we buy will not poison us. Yet adulterated food was once a threat.

Consider, by those standards, the failures of the banking industry, as admitted by the IIF itself. Its purely operational performance is now impressive. But competition does not work well in finance. The “product” of the financial industry is promises for an uncertain future, marketed as dreams that can readily become nightmares. Customers are readily swept away by exaggerated promises, irrational beliefs, misplaced trust and sheer skulduggery. So, too, are practitioners: basing risk management on limited data and inadequate models is a good example. Emotions count wherever uncertainties loom.

Boeing would not survive if the aircraft it built fell out of the sky. Yet in the financial industry, huge blunders are also almost always made in common. If everybody is in the dance nobody is to blame and, in any case, governments, horrified by the consequences of a collapsing financial system, will come to the rescue.

Until last August, I comforted myself with the thought that many of the crises of the past quarter-century occurred in relatively backward financial systems, even if institutions of the first world played a part in “seducing minors”. So things might, I hoped, be getting better.

That is no longer a plausible view. Once the US itself ran a large current account deficit the concomitant accumulations of internal debt generated huge losses, as the excellent new Global Financial Stability Report from the International Monetary Fund points out. The one good thing is that estimated losses of close to $1,000bn are widely distributed (see charts). That makes today’s situation less transparent, sadly. But it also means that the pain is more widely, and so much more safely, shared.

What then is to be done now? Interestingly, there is substantial convergence on the substance between the IIF and the authorities, as shown in a devastatingly critical recent report from the Financial Stability Forum on “enhancing market and institutional resilience”.*** Both agree, for example, that structures of compensation matter, as both I and others have argued. Both agree, too, that risk management was appalling.

The agenda laid out in the official report is lengthy. It includes: strengthening prudential oversight of capital, liquidity and risk management; enhancing transparency; changing the role and uses of credit ratings; strengthening the authorities’ responsiveness to risk; and improving arrangements for dealing with stress. But, it should go without saying, policymakers also believe regulation must be tougher. Given the damage done and the extent of the safety net provided, no alternative exists.

Yet I am not that optimistic about regulation either. Regulators are doomed to close the stable doors behind financial institutions that always find new and more exciting ways of losing money. It is, for this reason, crucial that the institutions, and unsecured creditors, feel some pain: the burned child fears the fire; singeing is less effective. Yet the fire must never burn too far, since that might destroy the entire economy.

If regulation is to be effective, it must cover all relevant institutions and the entire balance sheet, in all significant countries; it must focus on capital, liquidity and transparency; and, not least, it must make finance less pro-cyclical. Will it ever work perfectly? Certainly not. It is impossible and probably even undesirable to create a crisis-free financial system. Crises will always be with us. But we can surely do far better than we have been doing. In any case, we are doomed to try.

Burma deaths climb past 22,000 as aid begins

By Amy Kazmin in Bangkok

By Amy Kazmin in Bangkok

The death toll from the powerful cyclone that battered Burma rose above 22,000 on Tuesday – with another 30,000 still feared missing, as the international community mobilised water supplies, food, and shelter for the estimated 1m survivors.

With the magnitude of the disaster growing more apparent, the regime on Tuesday decided to postpone a vote on a new constitution in the parts of the country that were ravaged by tropical cyclone Nargis, which smacked into the country on Saturday.

Video: Burma cyclone

Full destructive force caught on video as death toll rises dramatically

State television reported that voting on the military-sponsored constitution – which the regime says will lay the foundation for a ‘disciplined democracy – would be delayed in Rangoon, the largest city, and the hard-hit Irrawaddy Delta until May 24.

However, it said the referendum on the charter – which has been slammed by critics as merely a tool to legitimise military rule – would go ahead as scheduled on May 10 in parts of the country unaffected by the catastrophe.

Slideshow: Burma cyclone

Burma’s cyclone catastrophe in pictures

Meanwhile – with the junta under fire from the Bush White House for its response to the disaster, Kyaw Hsan, the information minister, defended the military’s reaction, saying that the government was “doing its best” to help the victims.

“The task is very wide and extensive and the government needs the cooperation of the people and well-wishers from at home and abroad,” the minister said in a rare news conference in Rangoon, which has not had electricity since the storm struck, and where food and water are running short.

“We will not hide anything,” he said. “Please ask the people not to be duped by rumours or fabrication.”

Nargis, which packed winds of around 190km per hour, is the worst cyclone to strike Asia since a 1991 storm killed 143,000 in Bangladesh. Burmese authorities have said that at least 10,000 are thought to have died in a single town, Bogolay.

UN officials believe that the toll from the storm’s fierce winds and powerful storm surges will rise further in the coming days, as authorities make contact with low-lying coastal areas, many of which are now still submerged under water.

“The death toll is going to continue to rise, probably significantly, over the 15,000 we have at the moment,” said Richard Horsey, a spokesman with the UN Office for Coordination of Humanitarian Affairs.

“People just haven’t been able to get access to these towns and villages,” Mr Horsey said. “But what’s clear is that this is a major humanitarian situation by any standards…We are talking about 1m plus affected, and in need of immediate assistance.

The UN and the authorities are in discussions about how to import large quantities of relief supplies without becoming caught in cumbersome customs procedures, as well as on obtaining visas for UN staff to help oversee the relief operation.

After initially opening their doors to foreign aid organisations – especially to help it cope with an HIV/Aids epidemic – Burma’s military leaders have become suspicious of international aid workers, subjecting their movements to ever-tighter controls.

Relations between the regime and the UN grew prickly after the junta’s violent suppression of protests last September. The UN’s representative in Rangoon was expelled after the generals took umbrage at his public assertion that the demonstrations reflected public anger at increasing poverty.

The UN’s on-the-ground assessments of the storm-afflicted areas are being carried out by Burmese staffers, who do not require the same clearances to travel outside Rangoon as do foreign aid workers.