Idea banks can be trusted to police themselves ‘one of most dangerous of modern times’

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.

Short URL: http://www.ianfraser.org/?p=8461

Posted by on Oct 27 2012. Filed under Blog. You can follow any responses to this entry through the RSS 2.0. You can leave a response or trackback to this entry

8 Comments for “Idea banks can be trusted to police themselves ‘one of most dangerous of modern times’”

  1. Perhaps this is a bit of narrow a point to make, but is there a teeny wee contradiction between the FSA’s decision, having looked at its credit systems and what not, to grant HBOS advanced bank status in 2008 vs the FSA’s findings, having presumably reassessed these same credit risk systems, in 2012 as summarised in section 2.4 of its Final Notice to Peter Cummings?

  2. …and even after a global economic crisis of mammoth proportions regulators still cannot be trusted to police the banks. I wrote this in disgust.

  3. DumDum you make a very good point. It is scandalous that in its Peter Cummings ‘Final Notice’ document, the FSA said there were “known weaknesses in the control framework” at HBOS in 2006-08, and yet blithely awarded AIRB self-regulatory status to the same bank in January 2008. If it was already aware of control weaknesses, giving the bank AIRB status would be an act of supreme folly, wouldn’t it? IMHO, it is not just the people who were at the top of HBOS who deserve to be prosecuted (including the likes of Lord Stevenson, Sir James Crosby, Andy Hornby, Peter Cummings, Colin Matthew, Jo Dawson etc), but also the people at the top of the FSA. I have consistently said the FSA is entirely the wrong organisation to be tasked with producing ‘inquiries’, ‘investigations’, ‘reports’ etc into the failures of UK banks. It has massive conflicts of interest and a massive vested interest in ensuring that the truth does not come out.

  4. […] supposed to do is deliver regulation-lite. After all that’s happened in banking, there are many regulators who still don’t understand (or don’t want to understand) that they should be enforcing the law (itself a type of […]

  5. Ta for kind words. I’m a simple soul really. Like when the FSA stated (in its report) that “Corporate Division was the highest risk part of HBOS’s business” with this obviously having a major influence on the direction of questioning in the current parliamentay thingy, I got confused because the numbers in slide 57 of LBG’s 2012 half year results presentation (available online), suggest (judging by the impairment provision) that that title actually belongs to Ireland i.e. International. Thankfully, Mr Colin Matthew cleared this up when he recently told the MPs and what not that the Irish book in the division he used to manage was “30% mortgages, 50% retail, then SME the next largest part”, which is cool give or take the published numbers on slide 57 have the loan book as 45% commercial real estate, 29% retail and 27% “Corporate and other”. Lets hope the FSA, parliament etc., continue to avoid any meaningful research and analysis and keep relying on witnesses to present information in ways that are as “favourable” to themselves as possible or else dull facts might start getting in the way.

  6. When I watched Colin Matthew giving his evidence to the PCBS I sensed he was being somewhat economic with the actualité on the Irish loan book and a whole lot more….. Trouble is that Lord Turnbull and the others doing the questioning came across as (a) having skimped on their research (b) easily misled.

  7. Not being a journalist I’m afraid I’m not to up to speed with how to interpret the use of Alan Clark’s charming phrase. That and being uncouth results in me resorting to stuff like “utter whoppers”, “porky pies” and “very obviously self-serving and deliberate misrepresentation and obfuscation of facts despite these being readily available online”.

    On a completely different note, It is quite a challenge to reconcile Mr Matthew’s account of the international division as being primarily a retail (i.e. FIRST CHARGE mortgage as he explicitly put it) led business, given the reality of the Irish example or the references here


    to Australian commercial real estate lending vs his account of HBoS in Australia. You could suggest a pattern was emerging. You could, I certainly couldn’t. Thankfully, I’m sure the terribly well-informed and serious people in Parliament asking questions know much better than me thanks to the FSA review that focused pretty much exclusively on BoS Corporate and by definition ignored the potential for systematic issues at a group level and in other parts of said Group.

    As for the FSA, am sure Adair Turner’s mea culpas will more than make up for the fact that AIRB or advanced bank status as the name implies meant that in their expert judgement, after however many reviews and assessments, HBoS’s credit systems, processes and models were exactly that – advanced i.e. the most sophisticated and technically-competent then available globally, you know GLOBALLY. So much so in fact that US politicians argued against the introduction of Basel 2 because they knew it would give “advanced” banks a competitive advantage over many of the smaller (US) banks who couldn’t afford/weren’t willing to splash the cash advanced bank status entailed.

    Anyhow, I hope no one asks anyone from the FSA about the revolving door between it, banks and management consultancies (most obviously Oliver Wyman), because I think we’ve all heard enough about how important commercial experience is to last us a 100 lifetimes.

    To end on a topical note, this all makes me think of Jimmy Savile and the way in which he hid things in plain sight, like, you read Robert Peston’s book account of how Peter Cummings decided to stump up the cash for Philip Green’s M&S bid and think that’s (?) an “Advanced” bank credit process and decision-making system??

    I hope Mr Matthew didn’t have formal and documented membership of any of the credit sanctioning committees involved in any of the above or ABS for that matter. That would be awful as it would imply his repeated references to not knowing about corporate because he was in charge of the separate international division might be in need of some sort of “modification”.

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