October 20th, 2012 (updated October 31st, 2012)
On January 1st, 2008, some bright sparks at the FSA decided it was appropriate to grant Advanced Internal Ratings Based (AIRB) status to both Royal Bank of Scotland and HBOS. In doing so, the Canary Wharf-based regulator was effectively giving the two Edinburgh-headquartered banks carte blanche to calculate the risk-weightings of the assets on their own balance sheets, without any oversight from the FSA.
In granting them this status, the FSA was displaying absolute trust in the banks’ managements and sending a powerful signal to gullible third parties — including wholesale funders, depositors, borrowers, customers, counterparties, and investors who subscribed to the banks’ rights issues in June 2008 — that the banks were sound.
The change of status enabled the banks to run on an even thinner wafer of capital than they had beforehand (It’s worth noting that ABN Amro, acquired by RBS two months earlier, was never granted AIRB status by the marginally more effective and less “captured” Dutch regulator, de Nederlandsche Bank (DNB)).
With the benefit of hindsight the idea that banks such as these should have been trusted to do their own risk-modelling and then to use their own-internally generated models to determine their own capital requirements, was absurd, and almost certainly opened the door to an epidemic of ‘creative accounting’, impropriety and fraud.
The principles that underlay the FSA’s extraordinary decision and indeed its whole pre-crisis approach to regulating UK banks — including the underlying assumption that their boards of directors had integrity and that they knew what they were doing — were of course massive contributors to the financial crisis which has been crippling the UK economy for more than four years.
Writing in Project Syndicate Kenneth Rogoff, professor of economics and public policy at Harvard University and a former chief economist of the International Monetary Fund, said that the underlying principles of the global Basel framework of banking self-regulation were a by-product of warped academic thinking in the 1990s:-
In the mid-1990’s, academics began to publish papers suggesting that the only effective way to regulate modern banks was a form of self-regulation. Let banks design their own risk management systems, audit them to the limited extent possible, and then severely punish them if they produce a loss outside agreed parameters.
Many economists argued that these clever models were flawed, because the punishment threat was not credible, particularly in the case of a systemic meltdown affecting a large part of the financial system. But the papers were published anyway, and the ideas were implemented. It is not necessary to recount the consequences.
The disadvantage of “zero touch” regulation was of course that it enabled banks to indulge in all sorts of of elaborate chicanery — including the widespread abuse of structured investment vehicles, conduits, derivatives, securitizations, and collateralized debt obligations (CDOs) to minimize perceived risk, boost leverage, game the regulatory system and, above all, avoid tax — without anyone bothering to question them. Nor was it surprising that the activity got so out-of-control and fraud-riddled that it nearly brought down the entire financial system.
No wonder Andrew Bailey, the FSA executive in charge of supervising banks, recently told the Financial Times that there is are still some serious legacy issues arising from the now discredited AIRB- style laxity, especially where the valuation of commercial property assets are concerned. As the FT’s chief regulation correspondent Brooke Masters wrote:-
After two decades of working with failed and failing institutions including Barings, HBOS and Royal Bank of Scotland, he [Bailey] was openly sceptical of bankers’ ability to police themselves. Their commercial real estate risk models are “bogus”, he said, and their internal stress tests “are not stress at all, they’re mild, it’s a failure of imagination”. As a result, banks “never should have been allowed” to use their own models to determine capital requirements as currently permitted under the Basel rules.
The notion that bankers’ might be trusted to police themselves has always seemed ridiculous to me — even more so since it played such a pivotal role in the financial crisis. So it’s reassuring that mainstream figures such as Ken Rogoff and Andrew Bailey are now so unequivocal about it. What’s disturbing is that the Bank for International Settlements, which sets the Basel rules, is doggedly sticking to this particular form of necromancy.
As Dr Patrick McConnell, visiting fellow at Macquarie University Applied Finance Centre, wrote in ABC’s The Drum Opinion a year ago:-
Not only is the Basel process inefficient and opaque, it is dysfunctional. It is based on the philosophical furphy that banks can be ‘self-regulating’, and this laissez-faire approach to regulation allows banks to actually calculate their own capital, a strategy that failed miserably when tested by the global financial crisis. This has resulted in the farcical situation that a conservative bank, say for example in regional Victoria, is required to hold more capital on a relative basis than firms such as Citigroup and Royal Bank of Scotland which have stumbled from crisis to bailout since 2000. Can the Basel process be repaired? No, it’s too late, one bad set of rules every 10 years is just not good enough. A clean sheet is needed or else the world will stumble from banking crisis to banking crisis…
The Basel experiment in international regulation has failed and politicians should go back to basics, making sure their own house is in order before venturing out again to embrace a banking standard that is never going to be effective. Put Thomas the Tank Engine back in the train shed, until we learn how to drive it.