“It takes me about two hours to assemble a team of financial geeks and lawyers to devise a product or a transaction that would bypass any regulation coming our way,” a senior French banker said to me in the midst of the financial crisis in autumn 2008.
His confession captures the essence of the long-known dilemma confronting financial regulators, policy makers and the public in the aftermath of the most devastating financial crisis since the 1930s.
Whatever financial regulators come up with as part of policy reform, industry players are pretty likely to find a way to bypass it. At the very least they will minimise its effect.
Basel III is the latest attempt to arrive at an international banking accord, but it has been compromised by long and costly lobbying efforts by the banking industry. The implementation of some its most serious elements (such as new controls designed to ensure banks are more disciplined with the quality of assets they generate) has been postponed until 2018.
In 2009, there was much discussion in academic and policy circles that the wreckage created by the financial crisis might give the European Union a unique window to shape the international regulatory map of the post-crisis era. After the American mortgage market sparked the crisis, the thought was that it might mark the end of the US-led approach to financial governance. Five years on, it is the US authorities that appear, again, to be taking the lead.
The Dodd-Frank Act, a voluminous bill that charts the new principles of financial regulation in the US, was passed into legislation in 2010. American banks, according to most reports, are healthier and better capitalised, which is party reflected in faster economic recovery in the country as a whole. Interestingly, the US authorities have also been far more successful in identifying and pursuing cases of financial fraud in courts than their European counterparts.
The EU’s most far-reaching reform proposals, first voiced in 2008 and including the regulation of credit ratings agencies, have thus far born little fruit, aside from the ambitious idea of the European Systemic Risk Board. Riddled with national asymmetries and disputes, European policymakers have been trapped by the diversity of the political economies of its members states, and therefore by the relative importance of the banking sector in each country. Add to that the lingering impact of the eurozone debt crisis and the notoriously inefficient political apparatus of the EU itself.
In the UK, key banks, despite being owned by the state, have not been able to kick-start lending to the “real economy” without fuelling concerns about a new asset bubble. New restrictions on bonus pay in banking have been overcome in the industry. In the meantime, the regulators are calling for the return of securitisation – which includes the practice of bundling up loans and converting them into liquid securities – as a tool needed to kick-start lending and investment in the real economy.
Insufficient, late, or both…
Against this background, the question about the efficacy of financial reform and economic regulation appears obsolete. Whatever the interests of the regulators, the products of their efforts are bound to be either insufficient or late coming, or both. Four academic theories help explain why. And real-life experience in the financial system confirms that each of the positions holds a great degree of truth.
The first theory can be summarised as “throwing the baby out with the bath water”. This model economy relies on a flourishing and sophisticated financial and credit system. Without a sustainable and continuing supply of credit, investment slows down, economic growth stagnates and the economy shrinks. One of the major a reasons why the recession has been so long is precisely because post-crisis austerity measures have dampened the credit supply to the economy.
We then have to tackle the law of unintended consequences, or the Goodhart Law. It states that any financial regulation will be circumvented therefore it is smart to proceed with the reform cautiously. This wise principle accentuates the problem of time-lag. It takes time to work out where the risk lies in complex financial systems; it also takes time to understand connections between the official financial system and the shadow banking system. This problem only aggravates the larger phenomenon of a knowledge gap between the regulators and the industry.
Inevitably, it also suggests that prudent regulations and norms have to be devised after close consultation between industry experts, practitioners and policy makers. Unavoidably the eventual outcome of such a dialogue is compromise in which the initial plan for reform is augmented, often to reflect the interests of the private sector.
The third theory is a form of a mercantilist or realist theory of politics. It suggests that while in principle there may be a need for regulation, countries such as the UK have historically benefited from a lack of, or lax, regulations. This informs these countries’ approach to the direction and nature of the reform. France, which has a structurally different economic model, will be affected less than the UK by a radical version of financial reform; France’s approach to post-crisis governance is by default distinct to that of London.
Finally, we have the “captured state” argument. It suggests that in countries with large financial sectors, the government is effectively enslaved by private financial industry. In democracies, the political cycle tends to be shorter than the financial and the economic cycle: elected politicians who rely on votes simply do not have the time horizon that allows them to embark on a serious reorganisation of an industry which so often funds them. It is also clear that the post-2008 financial regulation will not be global; instead it will be dependent on national political economies and regulatory cultures.
The real question therefore, is not whether finance will fight off new regulations and controls. We know it will. The question is which form new compromise between the financial industry and the public authorities will take. The politics of financial crisis management, as well as academic research, suggests that such compromise is likely to assume many different forms. It is reasonable therefore to concede that we must prepare for an even more complex post-crisis regulatory topography, rather than the unified approach to global financial regulation that may have grabbed our imagination as the dust first began to settle. The ultimate question is whether any of the emergent regulatory nodes will be fine-tuned enough to mitigate the next financial crisis.