shaping the new financial architecture…

Too much attention is being paid to maintaining a status quo

Posted in Deleveraging, progress, TBTF by Kitty on January 6, 2010

From the Financial Times and opinion piece by former US Treasury Secretary Nicholas Brady…

Refocus the regulatory debate on essentials

By Nicholas F. Brady

Published: January 4 2010 19:57 | Last updated: January 4 2010 19:57

There is an inexorable drive on both sides of the Atlantic to finalise new rules, regulations and laws to place the financial system on a sounder footing. But in their zeal to act, politicians and regulators are looking through the wrong end of the telescope. Too much attention is being paid to maintaining a status quo that allows banks to continue engaging in the full range of activities to which they have become accustomed – admittedly under a number of regulatory constraints – without dealing with the fundamental causes of today’s critical difficulties.

Policymakers are intent on announcing all manner of new capital requirements, leverage ratios, “living wills” and directives on risk management, while brushing aside warnings by both Mervyn King, the governor of the Bank of England, and former US Federal Reserve chairman Paul Volcker that our banking system is unsound. Mr King and Mr Volcker are not alone in their concern that we may now miss a unique opportunity to secure core reforms.

The Basel Committee on Banking Supervision – the key multilateral authority on setting financial rules – dumped an 88-page present on governments and banks just before Christmas and, true to form, its focus was on technical ratios designed to force banking stability. The US House of Representatives last month voted for regulatory reform legislation that is no better. The House fails to consider the distinction between things that are critical and things that are merely important. The same mistake seems likely from the European Union, which is in the throes of establishing three new regulatory authorities.

The safety and soundness of the financial system is indisputably essential; without it, we have nothing. The long history of financial collapses proves this point. While efficiency, creativity and credit availability are important, they cannot be allowed to trump safety and soundness.

“Too big to fail” is the mantra of the day, but this mischaracterises the problem. The larger an institution, if soundly based, the more credit it can provide. What is of primary importance is the bank’s combination of activities. This is a key question that needs to be asked. It is not addressed, for example, in the House’s legislation or in the proposals sent to Congress by the Obama administration.

It is not too late to give centre stage to the question: should a bank’s operations include activities that could create a combustible mix and threaten the system as a whole?

I believe it is unsound for banking institutions to have the right to go to the Federal Reserve while pursuing lines of business that could result in such a combustible mix. Formulas that restrain such volatile operations – as are now being put forward on both sides of the Atlantic – will lead only to endless definitional arguments between the regulators and the industry. It is delusional to think that a regulatory system can be based on formulas – either the investment bankers will outwit the regulators or the regulators will overreact.

The architects of the new laws and regulations have been so focused on the financial institutions that they have lost sight of individual depositors. Everyone, however, has a relationship with a bank, while the average person has no interaction with the so-called shadow financial institutions. That is why there are 220,000 people working at JPMorgan Chase and only 31,000 employees atGoldman Sachs. Banks are the one place where the ordinary citizen touches the financial system. That citizen wants to be certain that he or she is dealing with an institution that is safe and sound.

It was this logic that ensured a clear separation in the US Banking Act of 1933 between deposit-taking commercial banks and the speculative investment banking business. I am not suggesting that we reinstate Glass-Steagall: underwriting activities are sufficiently refined so as to pose a much lower risk to the system than in Senator Glass’s day.

What I do suggest is a philosophy: do not allow the banking industry to create a combustible mix that will contaminate America’s central banking system. We will bitterly regret it if we fail to divide deposit-based banks from the shadow banking system.

There are a variety of means by which a fundamental restructuring of banking can be accomplished. The aim is to ensure, on the one hand, that institutions enjoying access to central bank windows and where deposits are governmentally insured operate in the safest manner, in the full interest of those whose deposits they take and whose businesses they provide with credit; and, on the other hand, that institutions engaged in speculative trading are subject to the vagaries and risks of the marketplace, subject of course to a precautionary range of regulations.

So far, politicians and regulators have ignored the fundamental issues, pursuing quick fixes rather than challenging the status quo. However, I do not believe it is too late to reopen the debate. We must start with fundamentals and the core interests of the public if we are to ensure that we will not stand condemned in the future for failing to learn from the mistakes of the past.

The writer, a former US Treasury secretary and senator, is chairman of Darby Overseas Investments Limited and a principal of Holowesko Partners

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