The end of laissez-faire

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By: Ian Fraser

Published: Sunday Herald

Date: 4 January 2009

REGULATION: The cataclysmic events in the financial world have turned the tide against faith in the self-correcting power of the markets. A special report by Ian Fraser.

ROLLING BACK the frontiers of state through privatisation and deregulation, a process kicked off by the governments of Margaret Thatcher and Ronald Reagan in the 1980s, was a policy intended to unleash pent-up entrepreneurial forces and boost economic growth. In financial services, however, the policy — which gathered momentum after “Big Bang” shook up the City — almost worked too well.

Alan Greenspan, the former chairman of the Federal Reserve, was one its most persuasive advocates. Such was his faith in the self-correcting powers of free markets, he was able to persuade politicians and regulators, not just in the US but elsewhere, to share his faith in the “efficient-market hypothesis”.

Against their better judgment, policymakers and regulators allowed themselves to be convinced that it would make sense for swathes of the financial markets — notably hedge funds, credit derivatives and mortgages — to exist in a near regulation-free zone. The Basel Committee on Banking Regulation also became convinced that the use of complex derivatives would limit risk and boost market efficiency.

In Britain the “light-touch” Financial Services Authority, which took over responsibility for bank supervision in 1997, adopted a similar laissez-faire approach (though its chief executive Hector Sants now denies that the body ever used the phrase “light-touch”).

However, many of the underlying assumptions behind this Greenspan-ian creed were deeply flawed. Rather than ensuring perfect markets, a regulatory vacuum coupled with a taxation system that favoured debt finance actually gave rise of a massive “shadow banking system”. In this, regulators were powerless to rein in an orgy of reckless lending. Unregulated markets had also become the perfect stamping ground for fraud.

It took the shocking events of September and October 2008, when several US, European and British banks came within a whisker of collapse, to persuade the policymakers and regulators of the error of their ways. The Bernie Madoff case, in which the former Nasdaq chairman allegedly defrauded investors to the tune of $50bn, further reinforced the urgent need for reform.

President-elect Barack Obama is making all the right noises. He attacked regulators, including the SEC, in the wake of the Madoff scandal. He said that financial markets “desperately needed” greater accountability and that one of his administration’s first initiatives will be to assemble a detailed plan for overhauling financial regulation. “We have been asleep at the switch,” said Obama. “We’ve had a White House that started with the premise that deregulation was always good.”

However, the financial services industry is not going to abandon some of its cherished freedoms without a fight. Even though it has been deeply humiliated and parts of it are now answerable to the taxpayer, some of the old arrogance survives. Some observers predict that 2009 is going to be characterised by turf wars between policymakers, regulators and the regulated over the best way forward.

The financial services industry, free-marketeers and right-wingers, will be arguing that stringent new regulations could be self-defeating, since the super-smart brains of Wall Street and the City would soon find ways around them. People in this camp will also warn that if any single jurisdiction, such as say the UK, were to introduce draconian new rules, then financial services firms will migrate to more loosely regulated jurisdictions, such as Ireland.

The rival camp favours more and smarter regulation and is made up of a rainbow alliance of market realists, believers in financial justice and even some diehard Marxists.

To many in this group, the injustices inherent in the financial services industry (including the 340-times pay differential between RBS’s call-centre workers and its former chief executive Sir Fred Goodwin) are tolerable when the industry is performing well. However, when parts of the industry are effectively bust and owe their continued existence to the generosity of taxpayers, the need for reform is self-evident.

Bill Hambrecht, the founder and chairman of pioneering brokerage WR Hambrecht + Co and OpenIPO, believes one solution for the mispricing of derivatives — which was ultimately what lay behind the breakdown in trust that gave rise to the crisis — is to force all trading in these complex instruments on to regulated stock exchanges. He believes this would ensure that pricing of hard-to-price instruments would rapidly become more fair and transparent.

Like many others, Hambrecht also believes that the credit rating agencies, which were prepared to slap AAA ratings on questionable financial instruments, must also be reformed. He suggests that their ratings might in future be funded through a tax on trading, rather than paid for by issuers and underwriters.

According to Nouriel Roubini, a professor of economics at NYU Stern School of Business, the bonus-driven culture at banks also needs to be overhauled. He says: “The system of compensation of bankers/traders should be re-evaluated. It is an important factor which distorts lending and investment decisions.”

Roubini, one of the few who can truthfully claim to have seen the current crisis coming, also believes the regulatory net needs to be extended. “If non-bank institutions including SIVs and conduits are to benefit from the government’s safety net, then the same regulation and supervision that is applied to banks should be applied to these systematically-important financial institutions, and on a permanent basis. Otherwise the moral hazard would be serious and severe.”

Some believe that a global, treaty-based organisation such as the International Monetary Fund ought to be given the additional mandate of providing a more coordinated global approach to regulation and bank supervision – thereby reducing the scope for so-called “regulatory arbitrage”. This is when private-sector players play one jurisdiction off against another.

Carmen Reinhart, a professor of economics at the University of Maryland and Kenneth Rogoff, a professor of economics and public policy at Harvard University, recently argued for a more international approach to bank regulation. In an article for the Financial Times they wrote: “Finding ways to insulate financial regulation from political meddling is critical to creating a more robust global financial system in the future. A well-endowed, professionally staffed, international financial regulator would offer a badly needed counterweight to the powerful domestic financial service sector lobbies.”

At their summit in November, the leaders of the world’s 20 largest economies were edging towards a consensus on such issues, saying that containing leverage must be a primary focus of any revamp of the global financial system.

Ngaire Woods, professor of political economy at Oxford University, believes there is also a need for “a special-function international court” that would be charged enforcing new global rules in banking and finance, reviewing global regulators, adjudicating in disputes, and offering uniform authoritative interpretations of the rules.

At a UK level, a number of specific reforms have been proposed. Professor Stewart Hamilton, a Scots professor of finance and accounting at Lausanne-based business school IMD, believes that a key reason that banks such as RBS and HBOS nearly collapsed last year was the incompetence of their boards, particularly the non-executive directors. He says: “I would strengthen the capability of people sitting on the boards of PLCs. They need to be people who are capable of exercising independent judgment. They should also have a proper understanding of business and a sufficient number must be reasonably experienced in the industry in which the company is involved.”

Other suggestions include that the Bank of England should resume responsibility for bank supervision and that there should be a much more concerted campaign to root out financial fraud.

Robert Skidelsky, professor emeritus of political economy at Warwick University, has already argued for a global exchange-rate system to replace the “broken” Bretton Woods agreement. Overall, however, Skidelsky believes the world is facing is a stark choice. “The effective choice is between a more regulated global capitalist system and its possibly violent break-up into a menagerie of warrior nationalisms.”


  1. Pingback: Ian Fraser - Business and Financial Journalist based in the United Kingdom Ian Fraser » Blog Archive » Have the regulators become aiders and abetters of financial crime?

  2. A key question to ask is whether, had completely prescriptive regulatory systems been in place in advanced economies over the last few years, this financial crisis would still have happened. I believe it would have. The “light-touch” regulatory system was not a fundamental cause of this crisis, but the regulators did institutionalise certain risk management practices that, as we have now seen, have serious flaws. However, a heavy-handed rules-based approach could just as easily have adopted those same risk-based measurement systems and embedded them in the regulatory framework.

    The measurement system known as value-at-risk (VaR) is the best example. This became a widely used measurement of risk in the 1990s when JP Morgan researchers popularised it. It measures risk boundaries in a portfolio over short time-frames, assuming a “normal” market. It’s very neat because it expresses risk as just a single number. Say a bank’s weakly VaR is $100 million. That means that over the course of the next week there is a 99% (depending on the “confidence interval” used) chance that the banks won’t lose any more than $100 million. It’s such a simple way to express risk that it quickly became adopted globally by banks. And when the SEC in the late 90s asked banks to disclose the market risks they were running to investors, this was what they turned to.

    Importantly, Basel II institutionalised it globally when it decreed that banks could use their own internal VaR calculations to set capital levels.

    But VaR has some major flaws. It lulls users of it into a false sense of security as it seems to show that everything is going okay and risks are low when in fact a “Black Swan” event can come along and wipe you out almost instantly.

    We now know that it was a mistake to rely on VaR to set capital levels, but a prescriptive regulator could just as easily have succumbed to relying on VaR as a guide to risk – but it would just have done it’s own VaR calculations rather than let the banks do them. It would no doubt still have used the same quantitative, and flawed, models to try to gain a sense of the massively complex and interconnected risks a modern bank takes.

    The roots of this crisis therefore lie not with regulators or any other single outfit, such as the rating agencies (which also jumped on the flawed models bandwagon) but with the rise of mathematical finance as a minority cultural movement. The roots of the crisis can probably therefore be traced all the way back to the 1950s and the academic work that produced “modern portfolio theory” – which kicked off mathematical finance.
    Bring together several other elements (the rise in computing power; the search for yield with highly-rated products etc) and you get to the heart of this crisis.

  3. Thanks very much for that explanation, John. I have to confess I had not yet fully familiarised me with the notion of “Value at Risk”, and therefore really welcome your concise summary. It is interesting to think that a single flawed assumption could have given rise to a crisis that has destroyed so much value and nearly brought down western capitalism, but the way you describe it – and following on from some conversations I have been having with Professor Stewart Hamilton at IMD – it seems entirely plausible. Presumably, this means it is the progenitors of VaR at JP Morgan that we should be “demonising” not Thatcher, Reagan or Greenspan?


  4. Pingback: Ian Fraser - Business and Financial Journalist Ian Fraser » Blog Archive » Can Cameron and Clegg overturn the legacy of “light touch” regulation?

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