Investment Markets » Banking and Finance
How Should The Financial System Be Fixed?
Do the old arguments against the excessive regulation of banks still apply, or are we in new territory now?
Something has happened on Wall Street and it isn't just the demise of a once venerable bank. Financiers discovered that they had created a series of risks the market couldn't cope with.
In the past, Bear Stearns would probably have been allowed to go to the wall; indeed, its rescue might strike many people as overly charitable. Yet the Fed put $30bn of public money at risk for the best reason of all: the public interest.
Bear is contracted to some $10trn of over-the-counter swaps, so imagine the financial nuclear winter had it collapsed. Its misfortunes have highlighted an inescapable truth: entanglement is the new doctrine, and the rules need changing to reflect that. The process is already under way in Britain, where the FSA has published a comprehensive mea culpa for its handling of Northern Rock. Indeed, Treasury officials believe they have a one-in-a-generation chance to improve the system.
An obvious area of weakness is the failure to ensure bank reserves. Regulators should also give serious thought to reforming bankers' pay: annual bonuses only encourage risky behaviour. And there should be a clear division between retail banks and those engaging in market trading – a principle established after the Wall Street crash of 1929, but since eroded. Finally, we need a proper international monitor of financial flows – a good task for the currently purposeless International Monetary Fund (IMF).
Yet, the problem with rules-based systems is that they create a false sense of security for both regulators and financiers. More to the point, they're useless at heading off future crises. Perhaps there was once a golden age when such regulation was possible but the recurrence of bank crises suggests otherwise.
Since financial stability is unattainable, the more important objective is to insulate the real economy from the consequences of instability. Banking supervision, meanwhile, should be limited to the weeding out of unfit persons. Matters like capital requirements and risk assessments should be left to the banks themselves.
The lobbies of Wall Street and the City will no doubt resist onerous regulation after this crisis is over. They may succeed but intellectually their position is now untenable. The Fed's decision to bail out Bear Stearns was the day the dream of global free-market capitalism died – deregulation has reached its limits.
Managing this unavoidable shift is a huge challenge but we must start in the right place, by recognising that the recent past is a foreign country.
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