Merge audit and compliance in financial services
In terms of employment growth, regulation must be the UK’s most successful enterprise. And we have been attempting to export it worldwide. The 4,000 strong Financial Services Authority (FSA) has now been divided into two main successors, the Prudential Regulation Authority (PRA), made part of the Bank of England, and Financial Conduct Authority (FCA), and a few minor ones. Hydra-like we can expect the combined total employment by the new bodies comfortably to exceed that of the FSA.
A couple of ironies here are firstly that financial services regulation was handed over to Brussels by Prime Minister Brown in 2009, leaving all these UK bodies merely with supervision of the rules set by the EU. Secondly, the level of malfeasance by banks in particular has grown in proportion to the numbers of regulations and regulators. The more regulators and regulations we have, it seems, the worse the banks behave. Part of the explanation is that the regulators have been incompetent at worst and invisible at best. If you doubt me, see the comments this month by the Commons Treasury Committee about the appointment of the new Chairman of the FCA.
And talking of invisibility, where were the auditors when this naughtiness was taking place? Auditors are theoretically employed by shareholders but, in reality, by the directors of the companies they audit. So you do not get a lot of auditors reporting that the directors are up to no good or turning blind eyes to practices they should be correcting.
To return to the issue of the numbers employed, the number of regulators, or regulatory supervisors, is not of much interest to a government which is cutting the size of the civil service (good) but recharging all the financial services regulatory staff costs back to the firms in the sector. Pontius Pilate was no better at hand-washing.
And the number of external regulatory staff is only a fraction of the total, arguably one third. The firms themselves have myriad compliance officers infiltrating the veins of the business and taking up the time of those managers trying to run it. The upside of that is that the better the internal compliance system, the less need there should be, in terms of person-hours, for the involvement of the external supervisors.
Much the same applies to internal audit: the better job they do, the less the audit fees should be.
But what, when all is said and done, is the difference in roles between external and internal auditors on the one hand and regulatory supervision on the other? Would it not be better to have fewer people combining audit and compliance and doing it properly, rather than the legions now employed and failing? And let us prohibit directors from appointing their own watchdogs, or rather poodles. A joint appointment committee of shareholders and PRA would give the audit/compliance team true independence.
Bank bailouts fix the wrong problems
The Daily Telegraph reported (16th January) that UK taxpayers would likely be called to contribute up to another £30bn. to further bail out RBS and Lloyds TSB. Their source was the Bank of England’s Financial Policy Committee’s (FPC) evidence to the Treasury Select Committee. The problem is largely artificial: banking fogeys see the crash as having arisen from inadequate capital to withstand shocks. They are wrong: more capital may have averted the need for the bailouts but capital shortage did not cause the crash.
The new international regulations-to-be (Basel III) focus on complex increases in tiered capital requirements. The fogeys, in pressing for higher capital ratios, are pressing for shareholders, including us, to bail out the banks once again. This new money, if the EU allowed the Treasury to do that, would sit on bank’s balance sheets waiting to withstand another 2008-like crash.
In the middle of a recession that is not going to happen. You may as well treat a patient dying of hypothermia with a liberal application of ice packs.
Requiring higher capital ratios will also cause banks to lend less and especially less to SMEs, the very businesses which could lead us out of recession if they had the cash to do so.
The FPC has a built in problem with trying to balance growth, which always involves risk, and stability, i.e. the absence of change. The problem is partly cyclical: just now we need growth but if and when growth again becomes unhealthy, we will need the ice packs.
Select Committees involve a lot of MPs showing and witnesses avoiding the questions. The best example of this time wasting during this particular session (yes, I watched two hours of it) was when Andrew Bailey was asked why UK borrowers paid higher interest rates, and UK lenders to banks lower, than their continental counterparts, i.e. why are UK bank margins wider at both ends? The British Bankers’ Association must have been proud of Bailey’s evasion but why did the Chairman, Andrew Tyrie, let him get away with it? The reality is that banking debates are full of technical confusions.
The high point of the session was the discussion between Brooks Newmark MP and Michael Cohrs, an independent, and independent minded, member of the FPC. It was this exchange that gave the Daily Telegraph its headline but it was a lot smarter than that. Rather than cut back on lending or increasing shareholder equity, banks could, and should, sell off their other assets.
More Quantitative Easing will be a sign of real trouble ahead
Fund manager and commentator Liam Halligan argues much the same as we do in a paper by Robert Miller due out later this month – that the first bouts of Quantitative Easing might have been wise, but any more could prove highly destructive.
The argument actually goes back to Hayek, who of course devoted many years of his career to the study of boom-bust cycles. These cycles, he concluded, start with the central bank easing credit – say, by keeping interest rates too low. That makes loans and mortgages cheaper, so householders buy bigger houses and businesspeople invest more on plant and equipment. But at the same time, low interest rates put off savers, and the funds needed for all this investment dry up. There is a crisis, and then a painful recession as investments are written off, house prices fall and productive equipment is sold for scrap.
What Miller explains elegantly in his forthcoming paper is how the banks amplify both the boom and the subsequent bust. That is because of the 'fractional reserve banking' system. When you pay money into your bank account, the bank keeps only a tiny amount on hand and lends out the rest to businesses. When those businesses buy equipment (say) from their suppliers, the suppliers pay that money into their account too. The bank keeps only a tiny amount on hand and lends out the rest to... well, you get the idea, it's a spiral. In fact, if the banks keep on hand just 3% of each deposit (as the Basel rules allow), then your original £100 turns into £2,219 of deposits after just 36 cycles. And when things turn sour and they start those same loans, exactly the reverse happens.
So the banks can create money out of thin air – and destroy it again – exaggerating the boom and the bust. That is why the Bank of England and the Fed reached for Quantitative Easing to repair the sudden post-crisis fall in the quantity of money. In so doing, they might well have saved us from a damaging depression.
So if Quantitative Easing can stop us going down, can more of it float us upward? No, says Hayek. In the boom, people invested their capital in the wrong places. More money will not do any good until productive assets are re-shuffled into more realistic uses. It just prolongs the problem. So if you see the authorities reaching for Quantitative Easting again, you can be sure that things are going to get worse, not better.
Another silly idea crashes and burns
It wasn't long after the financial crisis that we had every lefty worth their name crawling out of the woodwork insisting that this just proved how wrongly banking was structured. We must move back to local banks. Banks which had local politicians on the boards so as to make sure that the wider interests of the community were considered. Other stakeholders, like the unions must be included. And we most certainly had to divorce any investment banking from retail banking
There were a number of problems with this set of ideas: for example, none of the banks that went down in the UK did so because of investment banking. It was the wholesale bank run (Northern Rock), corporate hubris (RBS) or plain and simple bad lending (HBOS, various building societies).
But let's leave that aside. Let's assume that we did indeed have a local banking system. One that didn't have anything at all to do with investment banking. No CDOs, no CDS, no "trading", just plain vanilla lending in their specific regions. And we'll bring on board the local worthies, the local politicians, the union chiefs. Heck, we'll even make them non-profit shall we? Perhaps they should be owned by charitable institutions?
What do we end up with? Actually, we end up with the Spanish banking system:
Bankia stands as a reminder that Spain's property bubble—and the banking crisis that is its aftermath—had its roots in the intertwining of government and finance. Until the crash, Spain's cajas were community institutions closely tied to regional governments, and bank boards and regulators were peopled by party insiders willing to overlook lenders' real-estate excesses. Spain will see more disasters like Bankia's until these links are fully wrung out.
Note that here in the UK a few banks went bust (and rightly so), a couple were rescued as too big to fail and the rest became illiquid but not insolvent. They needed temporary funding aid but that could be and was repaid. That's what happened with the capitalist shareholding investment and retail bank mixing national system in the UK.
In the Spanish localised, politically directed and not for shareholder profit system absolutely all of that banking system went resoundingly bankrupt. No, not just illiquid: bust. In such large numbers that it's bankrupting Spain itself. So that's another one of those trendy lefty ideas that crashes and burns then, eh?
Oh, by the way, the only three banks in Spain that are still standing are the shareholder owned, for profit, mixing investment and retail banking, national and international ones.
Ring-a-ring-a-fences
The Parliamentary Commission on Banking has reported this morning and, like most of the talk leading up to and since the Vickers Report, is pre-occupied by ring fencing. Vickers, as you will recall, dealt with the demands for separating retail and investment banking by proposing that those banking groups involved in both should have separate subsidiaries for those sectors with no links between them.
Government discussions since then have been seen by some as, under pressure from the bankers, watering down the Vickers proposals. The Parliamentary Commission, au contraire, claims that Vickers did not go far enough and the fences should be “electrified”, i.e. any infringement would lead immediately to full separation. Sir John Vickers himself, in an email to the Today programme, quickly responded by saying that full separation would be an own goal.
What is weird about all this is that the financial crisis had little if anything to do with the lack of such separation. Retail banks, like Northern Rock, and building societies created a bubble of huge unrepayable debts and, quite separately, banks packaged up those “assets” to conceal their true nature and then played pass the parcel with the packages. Lehman Brothers was purely an investment bank. The entities that created the crash were already separated and separating the other groups would do nothing to prevent a future crash.
What is even weirder is the failure to recognise that banking today is an international, if not fully global, market. Financial solutions have to be found internationally. The Basel group are doing their best to achieve that and we now have three “Accords”. They focus, quite sensibly, on ensuring banks are adequately capitalised for the businesses they run. One can, and I have, criticised their proposals as an over-reaction which will penalise small businesses, but the point here is that the rest of world’s top regulators are not worrying at all about ring-fences.
Another part of the international dimension which the Parliamentary Commission fails to recognise is the EU involvement. Uncertainty about that undoubtedly contributed to the Northern Rock crash as Professor Tim Congden and others, including Sir Mervyn King, have pointed out. The UK is in course of handing financial regulation over to Brussels but what is for us to do and what for Brussels is unclear. The only thing that is clear is that the EU’s interventions will damage the competitiveness of UK banks and increase the costs for taxpayers.
So, not unusually, British chattering classes are dancing around playing ring-a-ring-a-ring-fence when the rest of the world gets on with regulating the real financial market. It is truly astonishing that this Commission should choose to focus its entire attention on the area that matters least. The consequence of adopting their suggestions, as Vickers himself seems to be pointing out, can only be that we will hobble our own financial sector at great cost to the economy and the British taxpayer.
Article: Financial thought crimes
The reforms to financial regulation that followed the 2008 crisis have been dead wrong, argues Deri Hughes. Interventionism and subsidies for established banks have choked competition and added even more layers of protection for established banks than existed before. The answer is to take the state out of the money and banking business.
The most tangible policy response to the ‘main’ financial crisis of 2007-9 has been the series of (on-going) reforms of the system of financial regulation in those countries that were most affected by the crisis in question. The need for such reform, and the nature of the reform that is thought to be required, have both been adopted as received wisdom by the majority of policy-makers. However, given the risks normally posed by received interventionist wisdom, it is worth giving some thought as to whether or not the current approach is, in fact, the most appropriate one. Accordingly, the purpose of this article is to consider the nature of the current reforms, and then to set out some alternative, and rather different, policy prescriptions.
Litigious Albion
In the United Kingdom, the attention that the financial crisis has received has been intense. Accordingly, the political and official appetite for reform has not waned. For example, as of November 2012, the Financial Services Bill is before Parliament, a Parliamentary inquiry into ‘banking standards’ is under way, and the draft Banking Reform Bill has been published. In addition, a Financial Stability Board (FSB) working group, led by the Chairman of the Financial Services Authority (FSA), the main British financial regulator, has announced its intention to focus on the activities of the so-called ‘shadow banking system’.
The regulatory reforms that have been, and are being, implemented can be divided into two broad categories.
Firstly, those relating to conduct.
Secondly, those relating to stability.
In essence, conduct regulation relates to the way in which financial services providers interact with clients, counterparties and the public at large. Its range is very broad, covering virtually every aspect of financial businesses’ commercial activities, and applying to businesses ranging from a self employed financial advisor to a universal banking behemoth.
Saint Mark
Canada’s motto of “peace, order and good government” may not stir the blood as America’s “life, liberty and the pursuit of happiness” or France’s “liberté, égalité, fraternité” but, all things considered, the country’s not in a bad place compared with other advanced economies. The banking system is solid, government debt and borrowing manageable and growth and inflation about as good as could be expected from a major trading nation.
The UK government now hopes that Mark Carney, the current governor of the Bank of Canada, can sprinkle a bit of that Canadian angel dust over here as the next governor of the Bank of England. Mr Carney certainly fits the bill of everyone’s image of the ideal Canadian – modest, polite, no-nonsense – someone you can have a perfectly pleasant dinner with.
To get a sense of the man, check out two major interviews earlier this year on YouTube – BBC’s HARDtalk in August and Reuters TV in January.
Saviours seldom meet mass expectations for salvation, especially when the sins have been so egregious and widespread. Mr Carney is no messiah, thankfully, but does know what the problems are, what it will take to fix them and what any central bank can actually do. That realism is what’s most needed now.
When asked his general view of the global economic situation, Mr Carney said: “We’re going through a period of de-leveraging across the advanced economies. There has been a three-decade increase in the amount of debt of governments and households and in some cases corporations across the advanced economies, notably the US, the UK and some parts of Europe…There’s going to be a multi-year process, really measured in decades, of reducing that leverage.”
So, no quick fixes, Cameron & Osborne, Miliband & Balls, and don’t pretend otherwise.
What’s a central bank to do then? “Central banks cannot solve this crisis. Central banks have to focus on, first, delivering price stability. It’s absolutely in no one’s interest to have deflation or runaway inflation…Secondly, we have to do our bit, and it’s not in its entirety, but our bit to keep the financial system functioning…Central banks can do all of that but just that…will not be sufficient to produce the growth and employment that people want. Other steps have to be taken by national governments.”
So, don’t go to your local central bank to cover the failings of your governments.
And what about Paul Krugman’s belief that central banks are too obsessed with controlling inflation and that a bit of inflation would be a good thing? “I think we’re appropriately obsessed with price stability. The risk in the UK has been deflation. And what the BOE did … (was provide)… additional stimulus through bond purchases - quantitative easing - in order to ensure that… there is not deflation in the UK. That price stability goes both ways…In order for (Krugman’s extra inflation) to make a difference …you have to get ahead of the bond market. You have to have a very large surprise, very quickly in order for it to make a difference on the fiscal side and it won’t work. “
How very Canadian – a sympathetic understanding of quantitative easing but no illusions about fooling financial markets on the dangers of inflation. Clearly a man who understands markets.
As a fellow countryman, I wish Mr Carney all the best and look forward to seeing this cool, calm and collected Canadian cope with Britain’s jumped-up politicians, hyper-active journalists and depressive citizenry.
A good man for an impossible job
Madsen comments on the new Governor of the Bank of England, Mark Carney. He is, says Madsen,
probably the best candidate to perform an impossible job. He had a good record in Canada, which weathered the financial storm better than most. He has sound views on controlling inflation, and on controlling public spending rather than distributing a largesse of newly printed and borrowed money.
His basic problem remains that the system of centralized control of a monopoly fiat currency may not be up to the task of servicing a modern economy without the wild swings induced by political oversight. Competing currencies, some commodity-backed, and with market interest rates, might be a better model. Carney would indeed go down in legend if he were able peacefully to transform the one system into the other.
To that I would add that Carney has been remarkably open-minded about both Austrian and NGDP-focused stories about the crisis. He certainly seems like a good appointment, but the task required of a central banker is a godlike one: to avoid disequilibrium between savings and borrowing, he must be omniscient about people's money demand and plans for the future. However able Carney might be, I'm not sure if that's a job that anyone can do.
What a Bank Governor should understand
I had a letter published in the Business section of Monday's Telegraph. It had to be abbreviated for lack of space, but I think the full text is worth repeating here because it explains what it is that the incoming Governor should understand.
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Dear Sir,
Next month a new Governor of the Bank of England will be appointed to replace Sir Mervyn King. A suitable candidate must not only possess rare qualities, but should also understand the causes of the financial crisis in order that they might make a recurrence unlikely. They should understand that the low interest rate policy pursued by governments and central banks to smooth the down side of the business cycle produced cheap money and easy credit that fuelled a housing bubble. This was intensified by implicit government guarantees in the US to support loans to borrowers with a high default risk.
This was exacerbated by rules that required banks to take more mortgage debt, done in the name of prudence, but in fact compounding regulatory error. Added to this was the fact that the artificially low interest rates drove fund managers into riskier investments because of the low returns on the safer ones.
If the person to be chosen as Governor understands this, they are unlikely to countenance future intervention designed to secure a politically acceptable outcome rather than an economically wise one. They will be unlikely, too, to punish by a regulatory stranglehold a financial sector that was far less culpable than the politicians who tried to make it serve their interests.
Yours etc.
Madsen Pirie
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Anyone who thought it was all down to greedy bankers taking reckless risks and thinks that tighter regulation is the answer is lacking in the insight and understanding we are entitled to expect from the next Governor.
Inflation: the ultimate corruption
Inflation, says Peter Twigg, is the ultimate corruption: the trick used by politicians to conceal vast spending and wastefulness. It is nothing less than a full-scale robbery of the people by the state, and it's high time that more of us realized how pernicious it really is.
The ultimate corruption is the single, most cynical, abuse of the people by the State (your government), in perpetrating the myth that inflation is an economic disease that government cannot stop. The truth is that government perpetuates inflation and that it remains in the government's interest to maintain a level of inflation. The truth is that government makes itself out to be the victim of inflation when in fact it benefits from inflation.
"With the exception only of the 200-year period of the gold standard (1714 to 1914 in Britain), practically all governments of history have used their exclusive power to issue money in order to defraud and plunder the people." FA Hayek, Choice in Currency
The truth is that government spends a lot of time and resources continuing the facade that they too are the hapless victims of this scourge called inflation. This illusion is maintained by social science academics having created a whole ‘science’ around the myth of inflation.
