Why financial regulation fails
The supposed prime objective of banking rules and regulation is to protect and reduce risk. As the credit crisis has clearly demonstrated regulation has failed to do so. Despite this the proposed solution is more regulation.
Rules and regulations are focused on mechanically risk weighting loans and allocating capital against that perception of risk in a prescribed formula that sounds complicated and is complicated. The capital charade and secrecy with government backing for large banks and almost all deposits means market scrutiny is all but removed from the banks. Detailed P&L and balance sheet data only goes to a few regulators opposed to the many that deposit, invest and research the banks thus limiting market review, risk assessment and analysis.
There is also a major skill set asymmetry with the many PhD brains of the banks easily able to outwit a few £60,000 a year PRA and BoE staff. Consequently the SIV CDO3, inverse IO and many other regulatory compliant but circumventing structures and strategies are created. The fixed formula driven official capital ratios all look to be unchanged at a level we are told is strong. The risk weighting of a loan to a business that is 1000% geared with no sales is the same as a loan to a 1% geared business that has a 50% operating margin from 50 year government contracts. The market would never be so simplistic and will always look forwards opposed to regulators that tend to look backwards. The market would allow much more leverage for genuinely low risk lenders and require much less for high risk lenders.
Today all banks essentially work to a very similar core capital ratio. The regulation based system allows banks to disclose as little as possible to as few as possible, complicating obscuring and circumventing. A market based system would encourage transparency, simplicity and full disclosure to as many as possible. Without regulation there would be little restriction on new banks being created and consequently there would be more specialists and more competition.
The abolition of regulation would make banks less risky. With banks that are too big to fail and deposit protection all banks can borrow cheaply regardless of the risks they take. Removing this will require banks who want cheap deposits to prove they are worthy of them. A market based pricing structure will be created with each bank having to fight for its funding. With very low real deposit returns the demand for disclosure, balance sheet transparency, simplicity and capital strength will be high. Where this is not the case real returns for depositors will be high.
With depositors now determining how much capital is required for any given deposit cost the subordinated debt now, now not ranking in line with the depositors will be priced based on the preference and equity capital structure. Today return on equity is maximised by reducing equity as much as the rules will allow with there being no correlation between capital strength and funding cost. In a market driven world the key funding cost will fall as equity increases. The correlation analysis below shows not only that pre-crisis capital and risk were inversely correlated, but also that risk and return were even more strongly inversely correlated. The strongest inverse correlation is, however, between Growth and Risk.
With rules based regulation that evolves slowly and usually only changes after a major problem banks can easily manipulate their balance sheets to comply with the letter if often not the spirit of the regulation. With the market/depositors setting a bank’s funding cost, the risk perception and analysis of anything new, complicated, or unclear should immediately impact the bank. Consequently the banks focus will shift to genuine economic profit based risk and reward analysis opposed to regulatory arbitrage.
Over time better banks will secure more funding at better terms rewarding appropriate risk assessment with those who operate inappropriately way failing. Evolution will be returned to the banking sector by the removal or regulation. Largely unregulated sectors such as retail have evolved rapidly providing customers with the Amazon service they desire replacing the Woolworths service they do not.
